If you want to understand how monetary policy under Ben Bernanke has fallen short and what kind of attitude we need from our next Federal Reserve president you can’t do much better than read this speech that Narayana Kocherlakota gave today.
His key point is that the central thing today’s monetary policy lacks is confidence in the power of monetary policy. He explains this in terms of the old days of too-high inflation. When the central bank expects that the central bank won’t be able to bring the inflation rate down, the public doesn’t expect it either. And if the public expects high and rising inflation, then high and rising inflation is what we’ll get. Today we have the opposite situation. If the central bank says it can’t or won’t do the things to maximize the economy’s growth rate, then the public will expect a depressed level of investment and the continued existence of excess capacity and low inflation. You need a central bank that’s not just willing to make some bond purchases, but more broadly willing to take responsibility for the movement of nominal figures.
Don’t straw man this for a moment as me (or Kocherlakota) saying that monetary policy is some kind of “panacea” or can “solve all problems.” Monetary policy can barely solve any problems at all. But on the very short list of problems that monetary policy can solve you will find “excess capacity that persists for a really long time.” How do we know there’s excess capacity? Because the inflation rate is so low. When the level of aggregate demand in an economy is straining up against the economy’s potential to produce, you get price increases. But today inflation is running at an extraordinarily low rate. Whatever the true “potential” level of output is, it’s higher than what we’ve got. Here’s what Kocherlakota wants us to do:
We’ve seen how the FOMC dealt with its problems in 1979 by adopting a goal-oriented approach to monetary policy. Given the parallels between 1979 and 2013, I believe that a goal-oriented approach would be useful again. In 1979, the FOMC’s goal was to return inflation to low levels as rapidly as it could. In 2013, the FOMC’s goal should be to return employment to its maximal level as rapidly as it can, while still keeping inflation close to, although possibly temporarily above, the target of 2 percent. Note that, by keeping inflation expectations well-anchored, the inflation requirement ensures that monetary policy remains effective as a form of employment stimulus.
Absolutely right. I sincerely hope that Barack Obama and his staff read this speech and take its message seriously when considering who should replace Bernanke.