Woodford siūlymas Bernankei

Bernanke needs inflation for QE2 to set sail
By Michael Woodford
www.ft.com
Published: October 11 2010 22:34 | Last updated: October 11 2010 22:34

Debate is raging within the Federal Reserve about whether to do more to stimulate the US economy. It seems many of its leading figures would like to, and the minutes of their last Federal Open Market Committee meeting, released Tuesday, will be read carefully for hints. Yet Ben Bernanke, Fed chairman, knows that a cut in rates, his usual tool, is currently infeasible. Therefore, speculation has turned to a return to quantitative easing (QE2), or large purchases of long-term Treasury bonds.

This would be a dramatic move. But we must not kid ourselves. It would have at best a modest effect in a large, liquid market such as Treasury bonds and, therefore, is unlikely to dig the US economy out of its current hole. There is, however, another option: for the Fed to clarify its “exit strategy” from its current, unconventional monetary stance. This would mean making clear that the Fed has no plans to tighten policy through increases in the federal funds rate, even if inflation temporarily exceeds the rate regarded as consistent with the Fed’s mandate. In short, the Fed should allow a one-time-only inflation increase, with a plan to control it once the target level of prices has been reached.

Such a move would be controversial within the Fed. But such a statement would merely be designed to help reduce expectations regarding both the path of short-term interest rates over the next few years and to increase the expected rate of inflation. Changes in these expectations would stimulate current spending: an expectation that low short-term rates will last for longer will lower long-term interest rates and an expectation of higher inflation should also reduce the perceived real rate of interest. Both of these steps would increase current expenditure by households and firms, giving the US economy a much-needed boost.

This proposal is different from that made in some quarters (and rejected by Fed officials) for an increase in the Fed’s inflation target. In order to obtain the benefits just cited, it is not necessary to make people expect a continuing high rate of inflation. Indeed, that would be counterproductive. To the extent that expectations of a permanently higher inflation rate would create uncertainty about the value of the dollar, for instance, they could easily make long-run real bond yields higher, rather than lower.

Instead, as suggested in a recent speech by William Dudley of the Federal Reserve Bank of New York, the Fed should commit to make up for current “inflation shortfalls” due to its inability to cut interest rates. If, for example, inflation was predicted to run half a percentage point below the Fed’s target for the next two years, the Fed could announce plans to offset this by allowing an additional one per cent rise in prices after that. Once the shortfall has been made up, the Fed would return to its previous, lower target.

Critics will say this will undermine the Fed’s credibility on price stability. They are wrong because the price increases allowed under this “catch-up” policy would be limited in advance. Catch-up inflation would simply put prices back on the path they would have followed had the Fed been able to cut interest rates earlier.

Others argue the opposite case: that a modest increase in prices would have too small an effect to boost the recovery. But the true value of such a commitment would be precluding a disinflationary spiral, in which expectations of disinflation without any possibility of offsetting interest-rate cuts lead to further economic contraction and hence to further declines in inflation. A commitment subsequently to offset any inflation deficit would allow higher future inflation to be anticipated in step with the size of the current inflation shortfall. This in turn would automatically limit the degree of disinflation that can occur.

The instinct of policymakers such as Mr Bernanke is to say less about future policy during a time of economic turmoil, on the grounds that the future seems especially difficult to predict at such times. Yet it is precisely when policymakers face unprecedented conditions that it is most difficult to assume that the public will be able to form correct expectations without explicit guidance. At times like the present, uncertainty about the future is one of the greatest impediments to faster recovery.

The writer is a professor at Columbia University and author of “Interest and Prices: Foundations of a Theory of Monetary Policy”