The list of Bernanke´s “homilies” on the importance of “nominal stability” is long. Between 1999 and 2003 he delivered speeches on the topic in at least four occasions, covering Japanese monetary policy (“Self-induced paralysis”) in 1999; the importance of Friedman´s “A monetary history” on November 8, 2002, where we read the passage that has become famous:
For practical central bankers, among which I now count myself, Friedman and Schwartz’s analysis leaves many lessons. What I take from their work is the idea that monetary forces, particularly if unleashed in a destabilizing direction, can be extremely powerful. The best thing that central bankers can do for the world is to avoid such crises by providing the economy with, in Milton Friedman’s words, a “stable monetary background”–for example as reflected in low and stable inflation.
Let me end my talk by abusing slightly my status as an official representative of the Federal Reserve. I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.
Followed shortly by the “evils” of deflation (“Making sure “it” doesn´t happen here”) on November 21, 2008; and 11 months later another “ode” to Friedman on the “Legacy of Free to Choose”. Scott Sumner has covered that one very nicely (here and here) but there can never be too much emphasis:
Ultimately, it appears, one can check to see if an economy has a stable monetary background only by looking at macroeconomic indicators such as nominal GDP growth and inflation. On this criterion it appears that modern central bankers have taken Milton Friedman’s advice to heart. Over the past two decades, inflation has fallen sharply and stabilized around the world, not only in the industrialized nations but in emerging-market economies and in even the poorest developing nations. Some central banks, so-called inflation targeters, have set explicit, quantitative targets for inflation; but all central banks, certainly including the Federal Reserve, have emphasized the importance of achieving and maintaining price stability.
Maybe I´m being too picky, but it seems from the quote above that Friedman´s “nominal stability” has collapsed to “price stability”. As events have shown that “adaptation” has proved both dangerous and deleterious for “nominal stability”.
Let me backtrack more than 40 years to Friedman´s two articles, both published in the Journal of Political Economy in 1970 and 1971. The first was “Theoretical Framework for Monetary Policy”, which was followed by “A Monetary Theory of Nominal Income”. A book with the title “Milton Friedman´s Monetary Framework – A Debate with his Critics”, edited by Robert Gordon and putting together both articles soon followed (1974). The “debaters” were Karl Brunner, Alan Meltzer, James Tobin, Paul Davidson and Don Patinkin.
I´ll just give two quotes from “A Monetary theory of Nominal Income” that are very relevant to the present situation.
When elaborating on the “correspondence of the monetary theory of nominal income with experience”, Friedman writes:
“In particular, the approach provides an interpretation of the empirical generalization that high interest rates mean that money has been easy, in the sense of increasing rapidly and low rates, that money has been tight, in the sense of increasing slowly, rather than the reverse”.
In the section “Short-Run Adjustment of Nominal Income”, Friedman says:
“For monetary theory, the key question is the process of adjustment to a discrepancy between the nominal quantity of money demanded and the nominal quantity supplied… What, on this view, will cause the rate of change of nominal income to depart from its permanent value (that I interpret as the level trend path it has been following for a long time)? Anything (maybe a house price crash and ensuing financial sector problems) that produces a discrepancy between the nominal quantity of money demanded and the quantity supplied, or between the two rates of change of money demanded and money supplied”.
And that´s exactly the best explanation for the “dive” in nominal spending (income) illustrated below, which happens due to the Feds exclusive focus on “price stability” and the “fear” of the consequences of rising oil and commodity prices, completely ignoring what was happening to money demand, letting the growth of money supply fall far below the growth of money demand.
It´s amazing that having read most of what Friedman wrote, and having “showered” him with praise in more than one occasion, Bernanke should have “forgotten” Friedman´s spirited defense of “nominal stability”, a concept much more general than just “price stability”.
Minds are so “screwed-up” that it is hard, in light of the foregoing, to make sense of Bernanke´s testimony on the H-H report to Congress on February 29:
The dual objectives of price stability and maximum employment are generally complementary. Indeed, at present, with the unemployment rate elevated and the inflation outlook subdued, the Committee judges that sustaining a highly accommodative stance for monetary policy is consistent with promoting both objectives. However, in cases where these objectives are not complementary, the Committee follows a balanced approach in promoting them, taking into account the magnitudes of the deviations of inflation and employment from levels judged to be consistent with the dual mandate, as well as the potentially different time horizons over which employment and inflation are projected to return to such levels.