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Saturday, November 24, 2007

Is Bernanke's inflation target futile?

Ben Bernanke's end run around Congress and the Humphrey-Hawkins bill last week in setting de facto inflation targets cannot make Barney Frank very happy. Frank is head of the House Financial Committee and a dogged critic of inflation targeting.

Frank sees the determination of the Fed under Bernanke to target inflation as misplaced, and feels the Fed is worrying too much about inflation and not enough about inecome inequality. "We are at the situation where distribution of wealth has become a significant economic issue," he said in July.

In February Frank told the Financial Times that Bernanke "has a statutory mandate for stable prices and low unemployment. If you target one of them and not the other, it seems to me that will be inevitably be favored." Transparency may be a smokescreen. "When you make it more transparent, you enhance its importance.... But when you make it public, you lose flexibility."

The Fed is mandated by statute to pursue two objectives for monetary policy -- low inflation and maximum employment. These two goals have become known as the "dual mandate." Absent an official or implicit employment target, an implicit target for inflation -- such as that issued November 19 by Bernanke -- seems to contradict the Fed's responsibility.

In a July 17 hearing, Frank's House committee heard economists weigh in on the subject.

Harvard University's Bejamin Friedman told the committee:
"The idea that economic policy should pursue price stability as a means of promoting more fundamental economic well-being, either currently or in the future, is not ground for pursuing price stability at the expense, much less the exclusion, of ... more fundamental economic well-being.

"It would be a mistake for the Federal Reserve to organize its monetary policy within an inflation-targeting rubric."
According to a Market Watch report by Greg Robb, "Friedman disputed the Fed's suggestion that an inflation target would improve transparency. He added that many of the world's central banks that have inflation targets "avoid any reference to the possibility of tension, even in the short run, between their inflation objective and any real outcome."

In the same July hearing, according to MarketWatch:

Prof. James Galbraith of the University of Texas said that inflation was killed by globalization in the early 1980s and would only come back if there was a collapse in the value of the dollar.

He said Bernanke should assure Congress "that interest rates will not be raised solely on the evidence of low or falling unemployment."

In fact, Bernanke's de facto inflation target is not only usurping Congressional power, but is inevitably flawed. As we will blog tomorrow, any effort to keep the falling dollar from appearing in higher inflation can only suppress the economy. The prices of imported manufactures from countries with flexible exchange rates must rise with the falling dollar, but more importantly, so will commodity imports like oil and metals. The strengthening of exports is good news for manufacturing companies and their employees, but it is no respite from higher prices. The prices of those goods with export markets will be bid up, and will rise for domestic consumers.

Keeping the lid on prices can be done only by suppressing wage rates. We've written the past two days that this is the Fed's preferred method, but its effect in the upcoming climate will only be to exacerbate the downturn.

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