Bernanke calls for a 4% inflation target

Well sort of.  It hasn’t got a lot of attention in the bond markets, but this week both Jon Hilsenrath in the WSJ, and subsequently Paul Krugman in the NYT have revisited Ben Bernanke’s paper Japanese Monetary Policy: A Case in Self-Induced Paralysis.  Bernanke wrote this in 1999 as an academic at Princeton University.  In it he calls on the Bank of Japan to set a “fairly high” inflation target to show that it “is intent on moving safely away from a deflationary regime, but also that it intends to make up some of the “price-level gap” created by eight years of zero or negative inflation”.  Bernanke argues that an inflation target of 3-4%, to be maintained for a number of years, would give the private sector some confidence about the authorities’ desire to get away from the deflation trap.

The BoJ obviously took no notice of Bernanke’s paper, and over a decade on from its publication Japanese CPI is still very negative year-on-year.  The question is whether Bernanke’s plan to help Japan recover from the stagnation it suffered post the collapse of its commercial property bubble reflects his thinking on what the Fed should do to help America recover from the stagnation it’s suffering post the collapse of its residential property bubble.  Currently the Fed targets a long term inflation rate of just 2%, but also has an objective to maximise employment.  We’d argue that the Fed has generally put the function has always been to wait for the unemployment rate to start falling before it hikes rates (the lag between unemployment falling and the Fed hiking has been especially long in the last two economic recoveries – see chart). 

However, a doubling of the US inflation target would cause carnage in the US Treasury bond market (who wants a 10 year bond yielding 2.7% when the Fed is targeting 4% inflation?) – and with one of the shortest debt maturity profiles of any developed economy, the interest burden cost of changing the target might be enough to trigger a credit rating downgrade (and in the medium term even a default?).  For this reason alone I think that Bernanke is unlikely to talk about a change in the target publicly (although others, including IMF Chief Economist Olivier Blanchard have been arguing for such a change).  Because of the political and public disregard for the runaway budget deficit, and the US Treasury’s behaviour in borrowing short to finance it (50% of the US Treasury market matures in the next 3 years), Bernanke’s hands might be tied.  The positive impact on private sector behaviour comes from loudly signalling a change in inflation behaviour, but the reliance on overseas investors to finance the US deficit makes such signalling very expensive, and possibly lethal.  So I don’t expect a change in Bernanke’s rhetoric around the inflation target.  But actions speak louder than words, and we will see the zero interest rate policy continue for the foreseeable future, and continued excursions into the world of quantitative easing.  As for the outcome of such policies, it would be foolish to put too much conviction as to whether the western economies end up looking more like Japan, or more like Zimbabwe.

Discuss Article

  1. John McD says:

    Go on, say it: Inflation will run away, USA can't afford future debt burden and only option will be to default on foreign payments. Chinese, Japanese and Saudis need to wake up.

    Posted on: 13/08/10 | 12:00 am
  2. Andrew Moore says:

    I don't know how many times the US authorities have managed to inflate their way out of trouble with deficits in the past and dump the consequences on others – the poor and foreigners.

    I cannot see this as a durable or equitable solution this time. It is time a global debate took place on the issues of control of population, distribution of wealth and an economic model that is inclusive of all of working age. Without such the chances of revolution will increase – we don't want that.

    The world at large is being distanced more and more from inclusion by dubious economics.

    Posted on: 13/08/10 | 12:00 am
  3. Clive Hale says:

    The real frightener is that "50% of the US Treasury market matures in the next 3 years"! Jim – how much is that on top of the deficit funded by additional Treasury sales?
    If they can "con" the market into expecting Japanese yields on Treasuries and start funding further up the yield curve (notice how the 30 year got a reprieve this week when everyone thought the "QE2" announcement excluded it – indeed it was absent but they have been making it up as they go along for some time now…) they could park  a fair lump of debt out there at a very low yield and then of course they'd have to find something else to worry about!
    There is a technical term for this of course – FUBAR

    Posted on: 14/08/10 | 12:00 am
  4. Anonymous says:

    Bernanke likes to remind everyone that he is an expert on the great depression and knows how to prevent it from happening again in the US. Apparently he is also an expert on Japan and its struggle with chronic deflation following its housing bubble in the 1980's. In fact Bernanke wrote an article in 2000 titled "Japanese Monetary Policy: A Case of Self-Induced Paralysis," where he goes on to lecture BOJ officials about what they could and should have done differently in order to to avoid a deflationary outcome. He goes on to postulate that the BOJ was not trying hard enough to stimulate the economy and that 0% interest rates are just one tool to beat deflation. The Fed Chairmen even goes so far as to assert that he knows how to escape a liquidity trap caused by 0% interest rates. The reason I bring this up is because it gives people a good idea of what Bernanke's next move may be. The US is dangerously close to falling into the dreaded "liquidity trap" as deflation takes hold and monetary policy loses its effectiveness.

    Here are some of his suggestions to the BOJ:

    Posted on: 31/08/10 | 12:00 am

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