“Thus spoke Zarathustra” (or the “Eternal recurrence of the same”)

Two years ago, in the JH 2010 version Bernanke concluded:

The Federal Reserve is already supporting the economic recovery by maintaining an extraordinarily accommodative monetary policy, using multiple tools. Should further action prove necessary, policy options are available to provide additional stimulus. Any deployment of these options requires a careful comparison of benefit and cost. However, the Committee will certainly use its tools as needed to maintain price stability–avoiding excessive inflation or further disinflation–and to promote the continuation of the economic recovery.

That was the hint for QE2 and markets reacted accordingly: Long rates rose, the stock market went up ,the dollar down and inflation expectations increased.

Those movements, however, were short-lived because there was no specified goal or target to guide monetary policy.

Two years later:

When significant financial stresses first emerged, in August 2007, the FOMC responded quickly, first through liquidity actions–cutting the discount rate and extending term loans to banks–and then, in September, by lowering the target for the federal funds rate by 50 basis points. ¹ As further indications of economic weakness appeared over subsequent months, the Committee reduced its target for the federal funds rate by a cumulative 325 basis points, leaving the target at 2 percent by the spring of 2008.

Yes, it did respond quickly, but just to avert a repeat of the banks “falling as dominoes” as in the early 1930s.

The Committee held rates constant over the summer as it monitored economic and financial conditions. When the crisis intensified markedly in the fall, the Committee responded by cutting the target for the federal funds rate by 100 basis points in October, with half of this easing coming as part of an unprecedented coordinated interest rate cut by six major central banks. Then, in December 2008, as evidence of a dramatic slowdown mounted, the Committee reduced its target to a range of 0 to 25 basis points, effectively its lower bound. That target range remains in place today.

As late as late July 2008, the view was that monetary policy would soon have to be tightened!  In fact, the Fed´s response to economic developments from the start of this recession revealed that policymakers were decidedly cautious. Furthemore, given the central role of expectations of future central bank policy in the monetary transmission mechanism, an easing or tightening of policy can consist of any action, or inaction, by the Central Bank that alters the public´s expectations. From that perspective it seems that monetary policy actions from late 2007 into 2008 could be classified as ‘irresponsible tightening’!

Despite the easing of monetary policy, dysfunction in credit markets continued to worsen. As you know, in the latter part of 2008 and early 2009, the Federal Reserve took extraordinary steps to provide liquidity and support credit market functioning, including the establishment of a number of emergency lending facilities and the creation or extension of currency swap agreements with 14 central banks around the world.

Just shows that the level of the policy rate is a poor indicator of the stance of monetary policy. It can be terribly tight even if the rate is zero!

 Unfortunately, although it is likely that even worse outcomes had been averted, the damage to the economy was severe. The unemployment rate in the United States rose from about 6 percent in September 2008 to nearly 9 percent by April 2009–it would peak at 10 percent in October–while inflation declined sharply. As the crisis crested, and with the federal funds rate at its effective lower bound, the FOMC turned to nontraditional policy approaches to support the recovery.

As the Committee embarked on this path, we were guided by some general principles and some insightful academic work but–with the important exception of the Japanese case–limited historical experience.

Where´s all the conviction Bernanke demonstrated in his recommendations for Japan back in late 1999? He could certainly have acted much more forcefully as Fed Chairman several years later.

In the Conclusion:

Early in my tenure as a member of the Board of Governors, I gave a speech that considered options for monetary policy when the short-term policy interest rate is close to its effective lower bound.³¹ I was reacting to common assertions at the time that monetary policymakers would be “out of ammunition” as the federal funds rate came closer to zero. I argued that, to the contrary, policy could still be effective near the lower bound. Now, with several years of experience with nontraditional policies both in the United States and in other advanced economies, we know more about how such policies work. It seems clear, based on this experience, that such policies can be effective, and that, in their absence, the 2007-09 recession would have been deeper and the current recovery would have been slower than has actually occurred.

As I have discussed today, it is also true that nontraditional policies are relatively more difficult to apply, at least given the present state of our knowledge. Estimates of the effects of nontraditional policies on economic activity and inflation are uncertain, and the use of nontraditional policies involves costs beyond those generally associated with more-standard policies. Consequently, the bar for the use of nontraditional policies is higher than for traditional policies. In addition, in the present context, nontraditional policies share the limitations of monetary policy more generally: Monetary policy cannot achieve by itself what a broader and more balanced set of economic policies might achieve; in particular, it cannot neutralize the fiscal and financial risks that the country faces. It certainly cannot fine-tune economic outcomes.

Unfortunately the conduct of monetary policy, by allowing spending to take a plunge, has strongly contributed to the fiscal and financial risks in place.

As we assess the benefits and costs of alternative policy approaches, though, we must not lose sight of the daunting economic challenges that confront our nation. The stagnation of the labor market in particular is a grave concern not only because of the enormous suffering and waste of human talent it entails, but also because persistently high levels of unemployment will wreak structural damage on our economy that could last for many years.

Over the past five years, the Federal Reserve has acted to support economic growth and foster job creation, and it is important to achieve further progress, particularly in the labor market. Taking due account of the uncertainties and limits of its policy tools, the Federal Reserve will provide additional policy accommodation as needed to promote a stronger economic recovery and sustained improvement in labor market conditions in a context of price stability.

Back in 2010 he ‘hinted’ on QE2, this time around Bernanke has all but confirmed a new round of ‘policy accommodation’. But has he learned that for that to be really effective he has to state a goal or target?

In a critical paper presented at the conference today, Woodford (page 44) suggests just such a target:

An alternative that I believe should be equally easy to explain to the general public, but that would preserve more of the advantages of the adjusted price-level target path, would be a criterion based on a nominal GDP target path, as proposed by Romer (2011) among others. Under this proposal, the FOMC would pledge to maintain the funds rate target at its lower bound as long as nominal GDP remains below a deterministic target path, representing the path that the FOMC would have kept it on (or near) if the interest-rate lower bound had not constrained policy since late 2008. Once nominal GDP again reaches the level of this path, it will be appropriate to raise nominal interest rates, to the level necessary to maintain a steady growth rate of nominal GDP thereafter.

Good to see that the idea is gaining traction.

Update: Lars Christensen has a post on Woodford´s paper

Update 1: Lars does an encore on Woodford´s paper

Update 2: Scott Sumner takes on the “low rates=accomodative monetary policy” syndrome.

Update 3: David Beckworth on Woodford´s endorsement.

Money and Monetary Policy are ignored

After reading the introduction to the just released book edited by John Taylor et al, I noticed the words money and monetary policy are conspicuously missing:

Government Policies and the Delayed Economic Recovery examines the reasons for the weak recovery from the recent US recession and explores the possibility that government economic policy is the problem.

The book concludes with key recommendations to help restore prosperity, including a broad-based tax reform that cuts tax rates, equalizes tax treatment across all types of capital, broadens the tax base, confronts entitlement spending, and, more broadly, reduces government spending as a percentage of GDP, as well as reforming unemployment benefits to reward job acceptance and accumulating human capital. The implications are clear: the future of both the American and the world economy is riding on an excellent diagnosis of the problem and appropriate changes in policy.

A unified explanation of the crisis is provided by monetary policy: It was responsible for the “depth” of the fall and is also behind the so-called “weak recovery”.

“At the edge” or “A Willy E. Coyote” moment

This is a sample of the high-level discussion in late July 2008:

Following the collapse of Fannie Mae (FNM) and Freddie Mac (FRE), Ben Bernanke’s Congressional testimony last week had Fed watchers predicting interest rates would remain flat, or possibly fall, by the end of the year.

But surging share prices last week and tough talk from two FOMC board members has delivered an expectations U-turn.

According to interest rate futures, investors had priced in a 42 percent chance of a 2008 rate hike following Bernanke’s testimony. But after falling oil prices and not-as-horrible-as-expected earnings from banks drove stocks higher through Thursday, a hike by year-end had been fully priced in by finicky investors.

Then on Friday, Minneapolis Fed President Gary Stern said that the Fed couldn’t wait for the double-threat posed by jittery housing and financial markets to subside in order to fight higher inflation. In similar remarks, the Philadelphia Fed’s Richard Plosser said this morning that rate hikes should be expected “sooner rather than later.”

All of this has helped push up the expectations of higher rates even further with a hike by October almost fully priced in at 90 percent.

What it in fact helped push was the “ball over the edge”.

 

You want more money? But I won´t give it to you! So while velocity was tanking (money demand soaring) the Fed thought it proper to pull in supply.

Forget real, think nominal

Michael Sivy writes at Time: The curious capitalist:

In addition to a host of warnings, last Wednesday’s Congressional Budget Office report did contain a little bit of good news. The economy will grow slightly faster in the second half of 2012 than in the first half, and inflation will stay extremely low, according to projections in the CBO’s Update to the Budget and Economic Outlook. The bad news is that unemployment will probably remain above 8%. The worse news is that next year the U.S. faces continued high unemployment, below-average growth and the risk of a double-dip recession.

The U.S. economy never built up much of a head of steam coming out of the 2007-09 recession, which saw the biggest drop in real GDP since the 1940s and the highest unemployment since the early 1980s. Historically, after such a major downturn ends, there’s typically a powerful rebound in which real GDP growth averages more than 4.5% annually over a period of two or three years and briefly hits annualized rates above 9%. By contrast, during the recovery that began in 2009, the economy has never grown faster than 4.5% and has averaged about 2.2% a year.

Yes, typically. But that doesn´t mean it´s in any sense “automatic”. The powerful rebound “typically” observed in RGDP is “typically” the result of the Fed cranking up monetary policy (which is not about “low” interest rates”) driving spending (NGDP) up forcefully. The chart clearly illustrates why there´s been almost no RGDP rebound at all. Just compare spending growth in the two instances.

And if you think inflation will take off like a rocket, think again:

And Michael Sivy plows on with more bad news:

And next year, the global economic situation figures to be even less hospitable to growth, which will make it harder for the U.S. economy to speed up from its current disappointing pace. Indeed, last week the ratings agency Standard & Poor’s released a report saying that the chances of a recession in the U.S. in 2013 had increased to 25%, up from 20% in February. A U.S. recession is by no means inevitable, but the domestic economy faces three large hurdles, any one of which could mean the difference between steady growth and another economic contraction.

“Reversal of Fortune”

In a post yesterday, Scott Sumner writes:

Bernanke claims money has been “extraordinarily accommodative,” based on the low interest rates and fast money supply growth.  Thus he simply walks away from his 2003 definition of the stance of monetary policy.  And no one in the press has called him on this inconsistency.

He has not walked away from his much more well-known denial of “liquidity traps” as preventing monetary stimulus, as that would make him look like a fool.  Instead he’s consistently argued that the Fed could do more, but is held back by certain unspecified “risks and costs” of further stimulus.

This approach to the problem is wrong on all sorts of levels.  There are no costs and risks of keeping expected NGDP growing along a 5% track, level targeting, all the “costs and risks” come from missing the target.  To take just one example, the ultra-slow NGDP growth after mid-2008 drove nominal rates to zero, and greatly boosted the demand for base money.  This forced the Fed to buy lots of assets, exposing them (allegedly) to risk of capital losses on those assets.  But that “risk” is caused by tight money, not monetary stimulus.  Even worse, it’s not really a risk at all, as the Fed is part of the Federal government.  Any losses to the Fed from falling T-bond prices are more than offset by gains to the Treasury.  Indeed that’s why inflation has traditionally been viewed as a boon to government coffers.

Coincidentally, today Sandra Pianalto, Cleveland Fed President discusses risks and costs:

Monetary policy should do what it can to support the recovery, but there are limits to what monetary policy can accomplish. Monetary policy cannot directly control the unemployment rate. It can only foster conditions in financial markets that are conducive to growth and a lower unemployment rate. At times, significant obstacles can get in the way.
… large-scale asset purchases can be effective. But our experience with these programs is limited, and as a result, they justify more analysis. For example, as the structure of interest rates has moved lower over time, it is possible that future large-scale asset purchase programs will yield somewhat smaller interest-rate declines than past programs. A related issue to evaluate is whether further reductions in longer-term interest rates would stimulate economic activity to the same degree as they have in the past.
The bottom line is this: I am supportive of actions that provide economic benefits with manageable risks. The FOMC’s policy actions to date have been important economic stabilizers and have acted to support the expansion(!). Yet today, we still find ourselves in a challenging economic environment – one in which we continue to rely on nontraditional policy tools. These new tools come with benefits and with risks … and we must constantly weigh both in our efforts to meet our dual mandate of maximum employment and stable prices.

I´m always surprised by FOMC participants concentration on interest rates and how the “programs have been successful in lowering them” and thus providing support to the expansion. It´s just the opposite as seen in the chart below. Every time a new “program” was announced or implemented, interest rates rose. And at the end of the programs they fell!

You see that rates fell when the financial crisis began with the Paribas announcement in early August 2007. With Operation Twist the effect was more muted: interest rates only stopped falling.

What they should want was a “program” that would give indications that the Fed was set in getting the economy back up. Interest rates, stock prices and inflation expectations would all go UP!

Jim Hamilton supports Bernanke´s “Creditism”

In a post today Jim Hamilton comments on the Fed´s balance sheet.

On the Fed´s emergency lending:

Some have criticized the Fed’s emergency lending on the grounds that the Fed took all these extraordinary actions and yet the economy still performed very badly in 2008:Q4 – 2009:Q2. I think this misses the point. I don’t believe that it was ever within the Fed’s (or anyone else’s power) to bring the economy quickly back to full employment. Instead, the purpose of the Fed’s emergency lending was to prevent a very bad situation from becoming even worse than it needed to be. The evidence we now have suggests that the Fed indeed accomplished exactly this.

On the Fed´s significant growth in holdings of U.S. Treasury securities, debt issued by Fannie Mae and Freddie Mac, and mortgage-backed securities guaranteed by Fannie and Freddie:

These measures, too, have been criticized on the grounds that, despite QE1 and QE2, the economy continues to disappoint. And here again, I think the critics have missed the point. I again maintain that it is not within the Fed’s power today to bring the economy quickly back to full employment. I nevertheless also believe that deflation– an outright decline in wages and prices– would make our problems even worse. For this reason, I have been a supporter of the Fed now moving ahead with QE3, though my expectations for what this will actually accomplish are low.

Let me understand. By its monetary policy mistakes the Fed has the “power” to crash employment but is powerless to take corrective monetary policy actions? And furthermore, Jim Hamilton has low expectations for what can be accomplished by the Fed´s actions! He´s not wrong to have low expectations, because so do I, unless the Fed  undertakes QE3 within a NGDP Level Targeting framework.

The chart shows that back in the early 1980s Volcker got things going after the recession by driving nominal spending much higher, something that Bernanke ‘refuses’ to even try after allowing it to crash after mid-2008!

And back then, inflation continued to trend down even after spending ‘shot-up’. But Bernanke has strong longstanding views, both on inflation targeting and the credit channel (see here for a primer).

Brace yourselves, the “Great Recession” will deepen! (If MR gets elected)

Glenn Hubbard says:

“You have to give Ben Bernanke and the Fed high marks for much of their actions,” Columbia economist R. Glenn Hubbard told Reuters TV on Tuesday, referring to the central bank’s actions during the 2008 financial crisis. Asked whether Mr. Romney would consider appointing Mr. Bernanke to a third four-year term, Mr. Hubbard replied, “I would certainly recommend that Chairman Bernanke get every consideration.”

Reporters immediately latched onto Mr. Hubbard’s comments as a sign of internal campaign disagreement, given that Mr. Romney has publicly dismissed the idea of re-appointing the Fed chairman. The better explanation is that Mr. Hubbard, the former chairman of the White House Council of Economic Advisers under George W. Bush, covets the Fed job for himself. What was he supposed to tell his questioner, “Fire Ben and hire me”?

Mr. Romney set the record straight Thursday, telling Fox Business News that he wants a “new person” to fill the Fed chairmanship who is focused on “monetary stability that leads to a strong dollar.” That’s solid advice for whomever takes the job next.

That´s quite the opposite of the monetary stability we want.

The Origins of the “Great Inflation”

The story begins in 1961 because that´s when economics came of age and economists an indispensable input into the formulation of executive policy decisions. According to Arthur Okun (1970), an active participant, first as staff member and later Chairman of the Council of Economic Advisers (CEA), in the economic decisions throughout  the decade:

“The strategy of economic policy was reformulated in the sixties. The revised strategy emphasized, as standard for judging economic performance, whether the economy was living up to its potential rather than merely whether it was advancing…the focus on the gap between potential and actual output provided a new scale for the evaluation of economic performance, replacing the dichotomized business cycle standard which viewed expansion as satisfactory and recession as unsatisfactory. This new scale of evaluation, in turn, led to greater activism in economic policy: As long as the economy was not realizing its potential, improvement was needed and government had a responsibility to promote it. Finally, the promotion of expansion along the path of potential was viewed as the best defense against recession. Two recessions emerged in the 1957-60 period because expansions had not had enough vigor to be self-sustaining. The slow advance failed to make full use of existing capital; hence, incentives to invest deteriorated and the economy turned down. In light of the conclusion that anemic recoveries are likely to die young, the emphasis was shifted from curative to preventive measures. The objective was to promote brisk advance in order to make prosperity durable and self-sustaining…The adoption of these principles led to a more active stabilization policy. The activist strategy was the key that unlocked the door to sustained expansion in the 1960s”.

But Okun also recognizes that:

“The record of economic performance shows serious blemishes, particularly the inflation since 1966. To some degree, these reflect errors of analysis and prediction by economists; to a larger degree, however, they reflect errors of omission in failing to implement the activist strategy”.

Funny how often policymakers and commenters fall prey to the “it wasn´t enough” argument, in this case not “activist enough” or, more recently, “the 2009 fiscal stimulus wasn´t big enough”.

In a 1936 review of “Keynes on Unemployment”, Jacob Viner conjectured that:

“Keynes’ reasoning points obviously to the superiority of inflationary remedies for unemployment over money-wage reductions. In a world organized in accordance with Keynes’ specifications there would be a constant race between the printing press and the business agents of the trade unions, with the problem of unemployment largely solved if the printing press could maintain a constant lead and if only volume of employment, irrespective of quality, is considered important”.

This seems consistent with what transpired in the 1960s, when we take into account the fact that to Arthur Okun:

“The stimulus to the economy also reflected a unique partnership between fiscal and monetary policy. Basically, monetary policy was accommodative while fiscal policy was the active partner. The Federal Reserve allowed the demands for liquidity and credit generated by a rapidly expanding economy to be met at stable interest rates”.

But Brad DeLong (1997) believes it is more accurate to see the views of Okun (1970) and of Samuelson and Solow (1960) as a consequence of the “very long shadow cast by the Great Depression” in that:

“The Great Depression had taught everyone the lesson that business cycles were shortfalls below and not fluctuations around, sustainable levels of production and employment”.

This exactly matches Okun´s view of the “gap that needs to be filled”.

More likely, both views are correct in that according to the policymakers at the CEA, “we´ll use every trick that will help us get there”!

The “employment obsession” of the 1960s policymakers ended up putting excessive pressure on the economic fabric. A steady rise in inflation was the outcome. The panel below shows how things progressed.

It appears that potential output calculations by the economists at the CEA were far too optimistic relative to potential output calculations made by the Congressional Budget Office (CBO) available today. In fact, by 1965, the year after the tax cut was enacted, the economy was beginning to “overheat”.  Both nominal spending and real output began to grow above potential levels. This is confirmed by what happened to inflation and unemployment, where the continuing fall in unemployment is indicative that the rise in inflation was not expected.

The CEA optimism is clearly demonstrated in this chart comparing actual and potential output calculated by the CEA in the 1969 Economic Report of the President (ERP) and the equivalent calculation by the CBO.

As the next chart shows, in the 1960s the Phillips Curve was “well behaved” in the sense of providing a “stable” relationship between unemployment and inflation. As Friedman (1968) argued, that “stability” should be illusory because as soon as workers began to expect inflation the curve would shift and “low” unemployment would only be maintained with rising inflation. As can be observed this is exactly what happened going into the 1970s.

What went wrong in the 1960s? There´s nothing wrong with the concept of potential real output, the guiding principle of policymakers in the sixties. The big problem is that it´s hard to estimate, especially in real time so that the chance that economic policy gets it wrong is high with the consequence that instead of higher real output the economy gets stranded with higher inflation.

Market Monetarist principles, on the other hand, do not emphasize the control of real quantities like unemployment or real output, but propose that monetary policy be geared to stabilize nominal spending – the dollar value of total spending – in the economy along a target level path.

The chart below gives an illustrative example. We calculate the nominal spending trend from 1954 to 1964 and observe what nominal spending would be if it had progressed along the trend path. Since nominal spending deviated systematically from that trend after 1965, the result was increasing inflation. At other times, indicated by circles, inflation is up or down depending on if spending is above or below trend.

How did the economy end up triggering inflation? The policymakers at the CEA were very well meaning and really thought they had learned to “conquer the business cycle”, keeping the economy at all times at or very close to its potential. To them the answer lay in the appropriate management of fiscal policy with monetary policy playing second fiddle and helping by keeping interest rates “low”.

By the end of his second year in office, President Kennedy was “sold on the idea”:

“It is a paradoxical truth that tax rates are too high and tax revenues are too low and the soundest way to raise the revenues in the long run is to cut the rates now … Cutting taxes now is not to incur a budget deficit, but to achieve the more prosperous, expanding economy which can bring a budget surplus.”

– John F. Kennedy, Nov. 20, 1962, president’s news conference

Concurrently, at the CEA, James Tobin (1974) was setting forth the “principles” that should guide policy:

1. The “new economics” sought to liberate federal fiscal policy from restrictive guidelines unrelated to the performance of the economy.
2. The Council sought to liberate monetary policy to focus it squarely on the same macroeconomic objectives that should guide fiscal policy.

That´s just another way of saying that the “policy mix” should contemplate expansionary fiscal (tax cuts) sanctioned by a monetary policy that kept the interest rate “low”.

Finally, post mortem, Kennedy´s tax cut was sanctioned. The IS-LM chart shows the rationale for Tobin´s “principles”. The tax cut would have maximal effect if monetary policy helped keep the interest rate “constant” so as not to discourage investment.

A few years later, in a debate with Walter Heller (President Kennedy´s first CEA Chairman) on “Monetary vs Fiscal Policy” (1969), Milton Friedman argued:

“…So far as I know, there has been no empirical demonstration that the tax cut had any effect on the total flow of income in the US. There has been no demonstration that if monetary policy had been maintained unchanged…the tax cut would have been really expansionary on nominal income…”.

The next chart shows that when nominal spending “took off”, interest rates and inflation followed suit.

At that point the policymakers began to have doubts. According to Arthur Okun:

“In 1965 the nation was entering essentially uncharted territory. The economists in government were ready to meet the welcome problems of prosperity. But they recognized that they could not provide a good encore to their success in achieving high-level employment”.

And as Gardner Ackley, then CEA Chairman put in a talk on “The Contribution of Economists to Policy Formation” delivered in December 1965:

“…The plain fact is that economists simply don´t know as much as we would like to know about the terms of trade between price increases and employment gains (i.e, the shape and stability of the Phillips Curve). We would all like the economy to tread the narrow path of balanced, parallel growth of demand and capacity utilization as is consistent with reasonable price stability, and without creating imbalances that could make continuing advance unsustainable. But the macroeconomics of a high employment economy is insufficiently known to allow us to map that path with a high degree of reliability…It is easy to prescribe expansionary policies in a period of slack. Managing high-level prosperity is a vastly more difficult business and requires vastly superior knowledge. The prestige that our profession has built up in the Government and around the country in recent years could suffer if economists give incorrect policy advice based on inadequate knowledge. We need to improve that knowledge”.

It seems, given what went on over the past four or five years that we still very much need to improve our knowledge.

But despite the doubts, the Government economists still kept faith on the power of fiscal policy to stabilize the economy near its potential. The financing needs of the Vietnam War which escalated at that time certainly made policymaking harder and confusing.

The next chart summarizes the history going into the 1970s. Desperate to keep employment at a  high level, monetary policy was consistently expansionary, parting a rising trend to nominal spending, which was translated into rising inflation.

As we´ll show in another post, the 70s inflation reflected the complete failure of monetary policymakers to realize that inflation was a monetary phenomenon, while at the same time maintaining the employment obsession of the previous decade.

A drastic revision of monetary policy had to wait until the early 1980s and following that change, how, unwittingly, a monetary experiment that could be construed as “stabilizing nominal spending along a level path” was practiced.

It´s all terribly depressing

Jon Hilsenrath reports:

Federal Reserve Chairman Ben Bernanke, in a letter responding to questions posed by U.S. Rep. Darrell Issa (R., Calif.), chairman of the House oversight committee, defended actions the Fed has taken to support the economy and said there is room for the Fed to do more.

“There is scope for further action by the Federal Reserve to ease financial conditions and strengthen the recovery,” Mr. Bernanke wrote in a letter dated Aug. 22, a copy of which was obtained by The Wall Street Journal.

The Fed’s “Operation Twist” program—buying long-term Treasury bonds and selling short-term securities—is still “working its way through the economic system,” Mr. Bernanke said. The program was first launched in September 2011 and in June 2012 was extended through the end of this year.

Asked by Mr. Issa if it were premature to consider additional monetary moves, Mr. Bernanke said that “because monetary policy actions operate with a lag,” the Fed must make policy “in light of a forecast of the future performance of the economy.”

The Fed chairman also said that the Fed’s bond-buying of recent years has “helped to promote a stronger recovery than otherwise would have occurred, and to forestall the possibility of a slide into deflation…by putting downward pressure on longer-term interest rates and contributing to broader easing in financial conditions.”

I particularly enjoyed learning that “because monetary policy actions operate with a lag…” Because everyone knows the Fed´s forecast of future economic performance has been pretty dreary and also because, contrary to what Bernanke says, monetary policy works with leads! (Note: Stocks turned sharply higher Friday, after Federal Reserve Chairman Ben Bernanke reiterated that there is further room for the central bank to act)

Bernanke should heed Bagehot:

“To lend a great deal, and yet not give the public confidence that you will lend sufficiently and effectually, is the worst of all policies; but it is the policy now pursued.”

– Walter Bagehot, Lombard Street

Turning a bad idea around: From a “Gold Standard” to an NGDP Level Targeting Fed mandate

James Pethokoukis puts it well:

I understand why some conservatives are fond of the idea of abandoning fiat money and returning to the gold standard, especially after the Great Recession and ongoing euro crisis — not to mention fears the growing national debt will prove inflationary or hyperinflationary. As George Bernard Shaw put it, “You have to choose between trusting to the natural stability of gold and the natural stability of the honesty and intelligence of the members of the Government. And, with due respect to these gentlemen, I advise you to vote for gold.”

But I am not there yet. As Milton Friedman famously said, ”Inflation is always and everywhere a monetary phenomenon.” Instead, I would prefer adjusting the mandate of the Federal Reserve so that monetary policy is less discretionary and more rule based.

One option is what could be called the “New Gold Standard,” the market-based targeting of nominal GDP.

And that has worked reasonably well even if it was not by design. If it were, it´s likely the late 90s early 00s instability would have been avoided and surely Bernanke´s disaster wouldn´t have materialized.