Chairman Bernanke vs. Governor Bernanke

I was looking at the official transcript of Ben Bernanke's last press conference in June and found this exchange interesting:

AKIHIRO OKADA.  Mr. Chairman, I am Akihiro Okada with Yomiuri Shimbun, a Japanese newspaper.  During the Japanese lost decade in the 1990s, you strongly criticized Japan’s lack of policies.  Recently Larry Summers suggested in his column that the U.S. is in the middle of its own lost decade.  Based on those points with QE2 ending, what do you think of Japan’s experience and the reality facing the U.S.?  Are there any historical lessons that we should be reminded about?  Thank you.

CHAIRMAN BERNANKE.  Well, I’m a little bit more sympathetic to central bankers now than I was 10 years ago.  I think it’s very important to understand that in my comments—both in my comment in the published comment a decade ago as well as in my speech in 2002 about deflation—my main point was that a determined central bank can always do something about deflation.  After all, inflation is a monetary phenomenon, a central bank can always create money, and so on.  I also argued—and I think it’s well understood that deflation, persistent deflation can be a very debilitating factor in—in growth and employment in an economy.  So we acted on that advice here in the United States, as I just described, in August, September of last year.  We could infer from, say, TIPS prices—inflation index bond prices—that investors saw something on the order of a one-third chance of outright deflation going forward.  So there was a significant risk there.  The securities purchases that we did were intended, in part, to end that risk of deflation.  And I think it’s widely agreed that we succeeded in ending that deflation risk.  I think also that our policies were constructive on the employment side.  This, I realize, is a bit more controversial.  And we’ve been consistent with that—with that approach.  But we did take actions as needed, even though we were at the zero lower bound of interest rates, to address deflation.  So that was the thrust of my remarks 10 years ago.  And we’ve been consistent with that—with that approach.

So Chairman Bernanke is claiming the "thrust" of his remarks about Japan were on its need to address deflation.  And since the Fed did just that with QE2, he believes the Fed under his leadership has been consistent with this approach.  Sorry Chairman Bernanke, but I don't think Governor Bernanke of 2002-2005 would completely agree with that assessment  nor do I think it gets to what Mr. Okada was asking.  For what Governor Bernanke originally advocated was more than just eliminating deflation.  He advocated the adoption of a price level target.  Here is Governor Bernanke in a 2003 speech:

For Japan, given the recent history of costly deflation, however, an inflation target may not go far enough. A better strategy for Japanese monetary policy might be a publicly announced, gradually rising price-level target.

What I have in mind is that the Bank of Japan would announce its intention to restore the price level (as measured by some standard index of prices, such as the consumer price index excluding fresh food) to the value it would have reached if, instead of the deflation of the past five years, a moderate inflation of, say, 1 percent per year had occurred... Note that the proposed price-level target is a moving target, equal in the year 2003 to a value approximately 5 percent above the actual price level in 1998 and rising 1 percent per year thereafter.² Because deflation implies falling prices while the target price-level rises, the failure to end deflation in a given year has the effect of increasing what I have called the price-level gap (Bernanke, 2000). The price-level gap is the difference between the actual price level and the price level that would have obtained if deflation had been avoided and the price stability objective achieved in the first place.

The key difference, then, between Governor Bernanke and Chairman Bernanke is that the former advocated for Japan an explicit price level target that allowed for catch-up inflation whereas Chairman Bernanke at best has advocated for the United States a vague inflation target that does not close the price level gap.  That is a big difference.  And note what Governor Bernanke says the closing of the price level gap would entail:

A successful effort to eliminate the price-level gap would proceed, roughly, in two stages. During the first stage, the inflation rate would exceed the long-term desired inflation rate, as the price-level gap was eliminated and the effects of previous deflation undone. Call this the reflationary phase of policy. Second, once the price-level target was reached, or nearly so, the objective for policy would become a conventional inflation target or a price-level target that increases over time at the average desired rate of inflation.

In other words, Governor Bernanke believed inflation should be allowed to temporarily rise above normal inflation rates until the previous price level trend was reached. He believed in a "reflation phase." One reason for doing so would be to reverse unexpected wealth transfers that occurred between creditors and debtors because of the unexpected deflation.  A second, related, reason is that it would help restore financial intermediation by improving balance sheets.  A third reason is that it would mean nominal spending is recovering as well.  Now contrast that with Chairman Bernanke who panders to the common view that any surge in inflation should be avoided; there is no room for nuance on this issue. 

Now maybe Chairman Bernanke believes that everything the Fed has done to date has returned the price level to its pre-crisis trend.  If so, then Chairman Bernanke can justifiably claim he is being consistent with his former self.  Some would challenge such a belief.  I would reply that even if the price level has been successfully reflated, at the end of the day it is only indicator of what really matters, nominal GDP (i.e. total current dollar spending) and its return to an appropriate trend level.  

I Hate to Keep Making This Point, But It Needs to Be Said

The anemic economic recovery can be tied to the ongoing elevated demand for safe and liquid assets.  Paul Krugman and Brad DeLong refer to this phenomenon as a liquidity trap; I like to call it an excess money demand problem.  Either way the key problem is that there are households, firms, and financial institutions who are sitting on an unusually large share of money and money-like assets and continue to add to them.  This elevated demand for such assets keeps aggregate demand low and, in turn, keeps the entire term structure of neutral interest rates depressed too.  (Note, that since term structure of neutral interest rates is currently low, it makes no sense to talk about raising interest rates soon.  That would push interest rates above their neutral level and further choke off the recovery.)  

As Scott Sumner notes, the weak aggregate demand also makes structural problems more pronounced.   Many observers, for example, claim that firms are not hiring because of all the regulatory uncertainty--e.g. Obamacare--coming from the federal government.  This may be true, but consider how firms would be acting if their sales were rapidly growing. At some point, the marginal benefit of another employee would exceed the elevated marginal cost of that worker coming from the regulatory uncertainty.  Firms flush with growing revenues and expected higher sales would feel less constrained by the regulatory changes when hiring workers.  To the extent, then, that regulatory changes are causing problems for the labor market, it is highly exacerbated by the low level of aggregate demand. 

Again, the weak aggregate demand can be traced back to the elevated demand for money and money like assets.  Here is one figure that is consistent with that claim.  This figure shows monthly job openings for the U.S. economy along with monthly money velocity, an indicator of the demand for money.  The relationship is surprisingly strong and is consistent with the implications of the figures shown in my previous post. 

Source: Macroadvisers, FRED, BLS

The question then is how to change the dreary economic outlook that is causing households, firms, and financial institutions to hold relatively large shares of money and money-like assets.  The best way to do it would be for the Fed to adopt a level target, such as a nominal GDP level target.  It would go a long ways in appropriately shaping nominal expectations and in bringing aggregate demand back to a more robust level.   Finally, ignore all those naysayers who say it cannot be done in a balance sheet recession or who say there is no magic lever that can revive the economy.  They don't know their history.  It worked for FDR in 1933-1936 and could work now too. 

Update:  Here and here are some posts that explain how a nominal GDP level target could restore aggregate demand to a robust level.

The Employment Report Shouldn't Be a Surprise

The demand for money and money-like assets remains elevated as indicated in the figure below.  This means nominal spending remains depressed.  Until this changes we shouldn't be surprised by employment reports like the one we got today.

Update: Here is the household sector's money and money-like assets as a percent of total household assets plotted against the same civilian-employment population ratio. The money and money-like assets include the following: cash, checking account funds, time and saving account funds, money market funds, and treasury securities.

How Should the Fed Prepare for the Eurozone Fallout?

Nick Rowe is concerned that the collapse of the Eurozone could lead to another Lehman-type event for the global financial system.  He is also wondering what central banks should be doing in preparation for such an event.  Nick is not the only one concerned.  Others have expressed concerned that financial contagion could arise from credit default swaps on Greek bonds or U.S. money market funds that are indirectly linked to the Greek economy through investments in the core Eurozone countries.  Even Fed Chairman Ben Bernanke expressed concern in his last press conference about the indirect exposure the U.S. economy has to Greek crisis:

 Answering a question during Wednesday's press conference about the U.S. financial system's exposure to Greece's problems, Bernanke went to great lengths to explain how U.S. institutions had very little "direct exposure" to Greece but considerable "indirect exposure" via their loans to European banks that have loaned to Greece. He drew attention to U.S. money market funds' "very substantial" holdings of European bank-issued commercial paper, which others have estimated to represent a whopping 40% of their assets
 ...
[M]emories of the chaos that followed the demise of Lehman Brothers in 2008 are strong and tend to color how investors, including U.S. money funds, respond to troubling events, such as the Greek crisis...The fear is that a default by Greece or a disorderly restructuring of the nation's debt could create contagion in the bond markets of other troubled sovereigns, thereby doing damage to the balance sheets of banks that have loaned to those governments. This could then raise fears about counterparty credit risks in short-term lending markets and, in a worst-case scenario, the paralysis of this vital source of bank funding. 

So what can the Fed do? Here is a suggestion: the Fed could say if total current dollar spending begins to plummet because concerns about the financial system are causing investors to rapidly buy up safe money-like assets (time and saving accounts, money market accounts, treasuries, etc.) then the Fed would begin buying up less-safe and less-liquid assets until the investors' demand for money-like assets is satiated such that they return total current dollar spending to its previous level. The Fed would need to stress the "until" part means it would purchase as many trillions of dollars of assets as necessary to restore total current dollar spending. Since this  process would take place over time, the Fed would also want to set a target growth rate for where it wanted the level of total current dollar spending to go.    

If the above sounds reasonable to you, then you should be a fan of nominal GDP level targeting.  It is exactly what the U.S. economy needed in early 2008 when inflation expectations and velocity started falling.  And it is exactly what the  U.S. economy needs now.  

One Interest Rate Hike Closer to Eurogeddon

The ECB today followed through on it plans to tighten monetary policy, the second time it has done so since April.  As I have noted before, tightening monetary policy is the worst thing the ECB could be doing right now if it truly cares about preserving the Eurozone in its current form.  If the ECB does care it should be easing monetary policy to help bring about a real appreciation in the core countries and real depreciation in the periphery.  Even if the ECB is indifferent there is still no justification for tightening monetary policy based on its objectives.  For, as Rebecca Wilder notes, inflation expectations are down and the growth in the ECB's targeted monetary supply is tapering off.  So this tightening cycle is truly bewildering.  Maybe the tightening cycle is to provide cover to the ECB buying up debt from the periphery or maybe the ECB is trying to hasten what seems to many the inevitable downsizing of the Eurozone. Either way, the band Europe has the right diagnosis of what all this really means.

How Long Until Employment Recovers?

Colin Barr awhile back had an article where he discussed the discouraging outlook for the U.S. labor market.  It got me wondering how long it would take employment to return to the level where the number of jobs created each month had kept up all along with the population growth rate.  Conventional wisdom says that the U.S. economy needs to create 125,000 jobs per month to keep up with population growth.   Growing jobs at this rate each month since the start of the recession and assuming the economy starts generating 200K, 300K, and 400K jobs per month produced the following chart: (Click to enlarge)

Sigh.  And to think most of this could have been avoided with more aggressive but systematic monetary policy.  

Market Share of Mortgage Debt Outstanding

Mark Thoma is frustrated to see some commentators once again push the view that Fannie and Freddie caused the economic crisis. When this issue arose back in late 2008, Richard Green's figure on the share of mortgage debt outstanding held by type of institution settled the debate for me.  That figure showed the GSE's share declined during the housing boom while the asset-back security issuers' share increased.  Here is an updated and slightly modified version of that figure: (Click on figure to enlarge.)

Source

The data is unambiguous here: Fannie and Freddie were not the immediate cause of the housing boom.   They may be guilty of a number of things, but directly causing the housing boom is not one of them.