TJP

 

Inflation Targeting: The Bernanke Way

By Byron A. Ellis – August 31, 2009

Inflation targeting is a monetary-policy strategy. It was introduced in New Zealand in 1990 and over 20 industrialized and non-industrialized countries use it. Its principal feature is an announced numerical inflation target, a monetary policy that focuses on an inflation forecast (called ‘inflation-forecast targeting) and public transparency and accountability.

Bernanke and his colleagues at the Federal Reserve Bank of New York argued in their book, “Inflation Targeting: Lessons from the International Experience” that inflation targeting is beneficial for the United States economy.

Michael Woodford in is article “The Fed's New Communication Strategy: Is It Stealth Inflation Targeting?” points to Chairman Bernanke's and Governor Mishkin speeches and indicates that these two Federal Open Market Committee (FOMC) members make it clear that the Fed conducts policy in the way advocated by proponents of "flexible inflation targeting," albeit without any official announcement of targets for policy.

James Galbraith, in his article on “Inflation Obsession: Flying in the Face of the Facts,” notes that in the United States were federal law stipulates full employment as a policy goal, Republican proposals to require the Federal Reserve to focus only on inflation surface regularly in Congress.

Thus, the Bush administration appointed one of the primary proponents of inflation targeting at the helm of the Federal Reserve to quietly implement the Republican proposal of inflation targeting.

The Republicans, including Bernanke and colleagues believe that inflation targeting would enhance American economic performance in the long run. However, Galbraith notes “they do not use it to refer to rising living standards, full employment, declining inequality in pay, or similar recent improvement in the American well-being.” Rather, he notes that they explicitly deny that monetary policy should be praised for expanding the economy.

Any central bank whose central premise is to control inflation by maintaining a tight monetary policy, such as what Bernanke and colleagues have done (see graph below, retrieved from StLouisFed.org), would cause the level of demand for goods and service to diminish over time and result in a recession. The graph below shows unambiguously the tight monetary policy between 2005 and the third quarter of 2008.

According to Galbraith, inflation targeting as presented by Bernanke and colleagues denies the central bank any important role in determining economic growth or employment. He also notes that Bernanke and colleagues claimed that a consensus exists among economists for inflation targeting and therefore the case is closed and consensus has settled the issue. However, no such consensus exists. Galbraith notes that many reputable economists, such as Eisner, Tobin, Samuelson, Solow, Vickrey, Fair, Medoff, Dickens, and others have never accepted the Friedman/Lucas view.

Bernanke and colleagues illusionary view that controlling inflation would improve economic performance has been debunked; instead of inflation it has created deflation in much of the world and put us in the worse financial crisis since the great depression. It has cause the American middle class to loose  a substantial portion of their wealth. Why? Because, in order to control inflation the Federal Reserve maintained a restrictive monetary policy and when exogenous events occur, such as wars or natural disasters, the price of certain goods or services increases, which creates a demand for real money balances. But, since the Federal Reserve is focused on inflation targeting, it failed to increase the stock of money during periods of rising crude oil prices. Therefore, the demand for real money balances exceeded the supply, which meant that the supply of assets exceeded the demand for real assets, such as bonds, housing, and other financial assets.

Thus, the reappointment of Bernanke is a clear indication that the administration does not understand the root cause of the current economic problems and will, more likely than not, continue to disappoint supporters of change.

SAVE DARFUR