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Fed
Chairman Bernanke
Brian
Trumbore
President/Editor, StocksandNews.com
Federal Reserve Chairman Ben S. Bernanke
gave his first major policy speech outside Washington
on Feb. 24 at Princeton University where he once taught.
Focusing on the importance of price stability, unlike
his predecessor you can actually understand him.
Following
are some key excerpts that may provide a clue as to
future moves by the Bernanke Fed.
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The
mandate of the Federal Reserve System has changed
since the institution opened its doors in 1914. When
the System was founded, its principal legal purpose
was to provide "an elastic currency," by which was
meant a supply of credit that could fluctuate as needed
to meet seasonal and other changes in credit demand.
In this regard, the Federal Reserve was an immediate
success. The seasonal fluctuations that had characterized
short- term interest rates before the founding of
the Fed were almost immediately eliminated, removing
a source of stress from the banking system and the
economy. The Federal Reserve today retains important
responsibilities for banking and financial stability,
but its formal policy objectives have become much
broader. Its current mandate, set formally in law
in 1977 and reaffirmed in 2000, requires the Federal
Reserve to pursue three objectives through its conduct
of monetary policy: maximum employment, stable prices,
and moderate long-term interest rates.
One
of my goals today is to consider the relationships
among the three apparently disparate objectives of
monetary policy. In particular, I will argue for what
I believe has become the consensus view, that the
mandated goals of price stability and maximum employment
are almost entirely complementary. Central bankers,
economists, and other knowledgeable observers around
the world agree that price stability both contributes
importantly to the economy's growth and employment
prospects in the longer term and moderates the variability
of output and employment in the short to medium term?.
Price
stability plays a dual role in modern central banking:
It is both an 'end' and a 'means' of monetary policy.
As
one of the Fed's mandate objectives, price stability
itself is an end, or goal, of policy. Fundamentally,
price stability preserves the integrity and purchasing
power of the nation's money. When prices are stable,
people can hold money for transactions and other purposes
without having to worry that inflation will eat away
at the real value of their money balances. Equally
important, stable prices allow people to rely on the
dollar as a measure of value when making long-term
contracts, engaging in long-term planning, or borrowing
or lending for long periods. As economist Martin Feldstein
has frequently pointed out, price stability also permits
tax laws, accounting rules, and the like to be expressed
in dollar terms without being subject to distortions
arising from fluctuations in the value of money. Economists
like to argue that money belongs in the same class
as the wheel and the inclined plane among ancient
inventions of great social utility. Price stability
allows that invention to work with minimal friction?.
Although
price stability is an end of monetary policy, it is
also a means by which policy can achieve its other
objectives. In the jargon, price stability is both
a goal and an intermediate target of policy. As I
will discuss, when prices are stable, both economic
growth and stability are likely to be enhanced, and
long-term interest rates are likely to be moderate.
Thus, even a policymaker who places relatively less
weight on price stability as a goal in its own right
should be careful to maintain price stability as a
means of advancing other critical objectives.
Let
me elaborate briefly on the relationship between price
stability and the other two goals of monetary policy.
First, price stability promotes efficiency and long-term
growth by providing a monetary and financial environment
in which economic decisions can be made and markets
can operate without concern about unpredictable fluctuations
in the purchasing power of money?.High and variable
inflation degrades the quality of the signals coming
from the price system, as producers and consumers
find it difficult to distinguish price changes arising
from changes in product supplies and demands from
changes arising from general inflation. Because prices
constitute a market economy's fundamental means of
conveying information, the increased noise associated
with high inflation erodes the effectiveness of the
market system. High inflation also complicates long-term
economic planning, creating incentives for households
and firms to shorten their horizons and to spend resources
in managing inflation risk rather than focusing on
the most productive activities.
Research
is not definitive about the extent to which price
stability enhances economic growth?Nevertheless, I
am confident that the effect is positive and see the
international experience as at least consistent with
the view that, in combination with other sound policies,
the maintenance of price stability has quite significant
benefits for efficiency and growth. That view appears
to be widely shared among policymakers, as governments
around the world have made extensive efforts to bring
inflation down over the past two decades or so, with
substantial success?.
[In
looking at today's oil price increases vs. those of
the 1970s] Thirty years ago, the public's expectations
of inflation were not well anchored. With little confidence
that the Fed would keep inflation low and stable,
the public at that time reacted to the oil price increases
by anticipating that inflation would rise still further.
A destabilizing wage-price spiral ensued as firms
and workers competed to "keep up" with inflation.
The Fed, attempting to gain control of the deteriorating
inflation situation, raised interest rates sharply;
however, initially at least, these increases proved
insufficient to control inflation or inflation expectations,
and they added substantially to the volatility of
output and employment. The episode highlights the
crucial importance of keeping inflation expectations
low and stable, which can be done only if inflation
itself is low and stable.
By
contrast, the oil price increases of recent years
appear to have had only a limited effect on core inflation
(that is, inflation in the prices of goods other than
energy and food), nor do they appear to have generated
significant macroeconomic volatility. Several factors
account for the better performance of the economy
in the recent episode, including improvements in energy
efficiency and in the overall flexibility and resiliency
of the economy. But, the crucial difference from the
1970s, in my view, is that today inflation expectations
are low and stable (as shown, for example, by many
surveys and a variety of financial indicators). Oil
price increases in the past few years, unlike in the
1970s, have not fed through to any great extent into
longer-term inflation expectations and core inflation,
as the public has shown confidence that any increases
in inflation will be temporary and that, in the long
run, inflation will remain low. As a result, the Fed
has not had to raise interest rates sharply as it
did in the 1970s but instead has been able to pursue
a policy that is more gradual and predictable. Of
course, the relatively benign state of inflation expectations
in a narrow range has been the product of Fed policies
that have kept actual inflation low in recent years,
clear communications of those policies, and an institutional
commitment to price stability.
Price
stability also contributes to the third component
of the Fed's mandate, the objective of moderate long-term
interest rates. As first pointed out by the economist
Irving Fisher, interest rates will tend to move in
tandem with changes in expected inflation, as lenders
require compensation for the loss in purchasing power
of their principal over the period of the loan. When
inflation is expected to be low, lenders will require
less compensation, and thus interest rates will tend
to be low as well. In addition, because price stability
and the associated macroeconomic stability reduce
the risks of holding long-term bonds and other securities,
price stability may also reduce the premiums that
lenders charge for bearing risk, lowering the overall
level of rates.
Source:
federalreserve.gov
--
Wall
Street History returns next week.
Brian
Trumbore
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