If it were only that easy. The risk is that central banks may delude themselves into thinking that the successes of the last 25 years on the inflation front are traceable to a rules-based monetary policy. The European Central Bank, for instance, is the world’s leading inflation targeter. America’s Federal Reserve has no such explicit mandate. Yet the Fed now wants to turn itself into the ECB. Newly appointed chairman Ben Bernanke was one of academia’s leading inflation targeters. Frederic Mishkin, a new Fed governor, is another luminary of this sect. They could well be a formidable team in pushing the Fed to adopt a price rule.
This could be a big mistake. Keep in mind that the Federal Reserve has waged a noble battle against inflation without any such rule. It took the wisdom and political independence of former Fed chairman Paul Volcker to break the back of inflation. Alan Greenspan preserved these hard-won gains. Neither central banker operated with a mechanistic rule–they relied on experience, judgment and discretion to get the job done.
Ironically, Bernanke’s performance since he took over as Fed chairman in February underscores the pitfalls of inflation targeting. His policy moves have been fine–three additional monetary tightenings following 14 moves by his illustrious predecessor. But on the communications front, he has committed a number of flip-flops that have left financial markets in confusion. If this record is indicative of Bernanke’s communication skills, a shift to inflation targeting could backfire.
And there are even deeper problems with this mechanistic approach. Inflation targeting ignores the elephant in the room–the excesses of the global liquidity cycle and the related profusion of asset bubbles that has surfaced since the late 1990s. Central banks, who have ultimate control over the flow from the liquidity spigot, are responsible for this dangerous state of affairs.
A CPI-type price rule could compound the negligence of bubble-prone central banks. In fact, we’ve already had a whiff of what might happen. By condoning the equity bubble in the late 1990s, Greenspan had to ease monetary policy aggressively when the U.S. economy veered dangerously toward a postbubble deflation. Bernanke, a Fed governor at the time, led the charge in encouraging this action. As a closet price targeter he thought the Fed should do anything and everything to avoid an “unwelcome deflation.”
That’s exactly what the U.S. central bank did. It slashed the federal funds rate to 1 percent and spurred the mother of all liquidity cycles. Saved from the ravages of a burst equity bubble, this approach gave rise to subsequent bubbles in bonds, emerging markets, commodities and property. This is a global problem. American consumers have tapped their asset bubbles–first equities and now property–and have taken income-based personal savings rates into negative territory for the first time since 1933. Lacking in domestic savings, the United States has to import savings from abroad–and run massive current account and trade deficits to attract the capital. By ignoring asset bubbles and fixating on the CPI, central banks have spawned huge and dangerous global imbalances.
That’s where it could come full circle. America can’t afford to have the Fed slip up right now. The European Central Bank is sending a clearer signal of its intent, and markets were well prepared when the Bank of Japan finally ended its zero-interest-rate policy last week. With chairman Bernanke waffling, the relative credibility factor could swing away from the Fed. That could lead to a loss of confidence in dollar-based assets, with serious consequences for bonds and stocks.
On July 19, Bernanke will appear before the U.S. Congress to discuss the Fed’s policy strategy. This is a time for discipline and consistency. A dollar crisis would be a steep price to pay for the folly of inflation targeting.
