Bernanke’s Test

Here at last is a book about the US Federal Reserve that is neither impossibly technical nor populist. The author is obviously extremely familiar with the American financial and political scene. But, perhaps because he is resident in Belgium, he avoids the twin sins of US-type blockbusters of excessive length and arch chapter headings and introductions such as: “While Joe Smith was trimming his lawn the telephone rang ... it was the White House.”

Inevitably, Johan Van Overtveldt is more enlightening about Ben Bernanke’s predecessors as chairman than Bernanke himself, who is not long into his tenure. He makes it clear the big reduction in US inflation took place under Alan Greenspan’s predecessor, Paul Volcker, a Democrat and no monetarist, but who used monetarist rhetoric in 1979-82 to launch a successful blitz on inflationary expectations.

Greenspan was at one time regarded as a miracle worker. No less a person than Senator John McCain once declared that, if Greenspan should die, “I would prop him up and put a pair of dark spectacles on him”. More recently, the pendulum has swung to the other extreme and he has become a scapegoat for all the world’s troubles. Van Overtveldt steers a healthy middle course. He concedes that the former Fed chairman wrongly neglected regulation and supervision. But he defends the low interest rates earlier in this decade.

He makes short work of the anti-intellectual Wall Street short-termists’ gibe against “Helicopter Ben”. Such people can no more understand a thought experiment than I could a complex derivative. On the crucial issues of interest rates and asset prices there was hardly a hair’s breadth between Greenspan and Bernanke. Bernanke’s distinguishing feature has been his espousal of inflation targets.

Inflation targets began with the realisation that money supply was too difficult to define and its velocity too volatile for it to serve as a short to ­medium-term objective. So targeting consumer prices seemed the best way to preserve the insights of monetarism without so many hostages to fortune. Inflation targets were adopted in many countries, although Bernanke never succeeded in getting them through the Federal Reserve Board. These targets depended on some important assumptions, not always fully articulated:

1. The central bank could always determine short-term interest rates by market operations.

2. Short-term interest rates exercised a powerful influence on activity both directly and through their influence on longer rates.

3. Asset price bubbles and bursts could best be tackled indirectly, to the extent that they they influenced consumer price inflation.

4. Activity and employment could be sufficiently influenced in a counter-
cyclical direction by allowing time – say, two or three years – to return to the target rate of inflation in the face of deviations in either direction. They could also be helped if the government aimed for some definition of budget balance, but accepted the automatic deficits that accompanied recessions and the surpluses that accompanied booms to run their course.

5. By aiming at a low but positive rate of inflation, real interest rates could be varied in either direction without running against the zero interest rate floor.

6. Central bank operational ­independence was a useful adjunct.

7. A relationship, known as the Phillips Curve, between unemployment or the output gap and changes in the inflation rate could be used to determine policy if the central bank “looked through” short-term shocks.

There were human side-effects. Central bankers began to see themselves mainly as economic managers, and the tasks of financial regulation and supervision, whether or not delegated to separate agencies, were downgraded. This model always had critics. I made no secret of my preference for some variant of a nominal gross domestic product objective. But, as the inflation target model seemed to work astonishingly well in so many places around the 15 years of 1992-2007, dissenters found it difficult to secure a hearing. A fair judgment might be that the regime is well-suited for normal business cycles but is ill-suited to emergencies.

To be fair, Bernanke now seems to accept the case for a policy for asset prices. Moreover, as Van Overtveldt reminds us, the US has some instruments other than interest rates for influencing them, although they are spread over too many agencies. But the present period of confusion and hopeless pessimism is quite the wrong time to erect new long-term guidelines. Quantitative easing – the respectable name for helicopter droppings of money – is now the name of the game.