Since Bernanke began blogging I have complained that he doesn´t go to the “heart of the matter”. That is, recognize that the Fed, under his command, bungled.
In fact, the mess-up is likely due to his “love affair” with inflation targeting, with that “love” manifesting itself at the worst possible moment, because the rise in headline inflation that occurred at the time was the result of a negative supply shock, which should not have unduly worried the “lover”.
Bernanke has a deep knowledge of economic history, so he knew about the thought process on economic stabilization that evolved over the decades since the early 1970s. To recall, on becoming chairman of the Fed, Volker challenged the Keynesian orthodoxy which held that the high unemployment high inflation combination of the 1970´s demonstrated that inflation arose from cost-push and supply shocks – a situation dubbed “stagflation”.
Volker´s challenge placed inflation as the FOMC´s top priority. He also brought to the fore of policy discussions the ideas developed during the previous 12 years – since Friedman´s address to the 1967 AEA meetings – on the importance of inflation expectations.
To Volker, the policy adopted by the FOMC “rests on a simple premise, documented by centuries of experience, that the inflation process is ultimately related to excessive growth in money and credit”.
This view, an overhaul of Fed doctrine, implicitly accepts that rising inflation is caused by “demand-pull” or excess aggregate demand or nominal spending.
Now, why is this new “doctrine” consistent with the observed increase in economic stability?
Given the cost-push “doctrine” on the inflation of the 1970´s, the Fed would compensate the fall in AS with an increase in AD, an expansionary monetary policy. This followed from the perceived flatness of the SAS curve below potential output. Since this was a flawed doctrine, over time we should observe trend growth in AD (or nominal expenditures).
Volker, on the other hand, believed that inflation was the result of excessive AD. So nothing more natural than to assume that the Fed should increase its responsiveness to the growth in nominal spending. How would this change in “doctrine” (from regarding inflation as a “cost-push” to “demand-pull” phenomenon) show up in the data?
Recall that under the cost-push “doctrine” the Fed would react vigorously to negative output gaps making policy expansionary, so nominal spending would grow. Under the new “doctrine” the Fed doesn´t react much to supply shocks since a negative supply shock, for example, would decrease real output an increase prices with little effect on nominal spending, but would react vigorously to AD or nominal spending shocks.
Therefore, under the new “doctrine”, policy would make AD growth stationary, in which case AD growth will not show a rising trend as under the cost-push “doctrine”. The chart illustrates.
The main difference between the two “doctrines” is not the change in the Fed´s responsiveness to inflation as argued by, among others, John Taylor and Bernanke, but the changed responsiveness to aggregate demand or nominal income growth. A collateral effect of the change in “doctrine” shows up in the reduction and stabilization of inflation and decreased volatility in real output.
The Fed never explicitly targeted anything – inflation or nominal income (AD) growth – but implicitly you could say it targeted nominal AD along a 5.5% growth path growth with Volcker and Greenspan.
The chart below provides, to my mind, compelling evidence about the change in doctrine and its stabilizing consequences. One implication is that during all this time, “Inflation Targeting” was just a red herring!
And the biggest victim of the “red herring” was Bernanke himself. Since forever he has been a great defender of the “IT modus operandi”, and exactly when he put it in practice he “pushed the car off the road” and got a “depression” as the result. Later, by making the “red herring” @2% official policy target, he showed he was clueless about the true cause of the monetary policy foul-up!