Why did Bernanke change his mind?
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The Fed’s actions last Thursday have been widely seen as a fundamental shift in its monetary policy, and its communications with the public. The tone of the FOMC’s statement, and of the Chairman’s subsequent press conference, clearly gave much less weight to the control of inflation than usual, and much more weight to the need to achieve a substantial reduction in unemployment. Certainly, the latest round of quantitative easing is the first to have occurred with little or no threat of deflation in the offing, and markets have responded by raising inflation expectations significantly.
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It is hard to argue with the markets on this. In fact, it is even possible that the Fed leadership is becoming comfortable with the notion that inflation might exceed its 2 per cent long term target for a while. If so, this would be a very significant step, representing the first such move by any of the major central banks since the 1990s.
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Until now, the standard mantra among the major central banks has emphasised an inflation target of around 2 per cent, and policy has usually been set with that primary objective in mind.
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Unemployment, meanwhile, has been left to adjust automatically towards its “structural” rate over a horizon of several years. Mr Bernanke indicated last week that he is no longer satisfied with this approach.
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The Fed of course officially has a dual mandate covering both maximum employment and price stability, but it has always actually acted as if it has given precedence to the inflation objective. It is easy to see this by looking at the economic projections of the FOMC. These have been willing to tolerate prolonged periods in which unemployment is above the Fed’s estimate of the “structural” rate, while inflation almost never exceeds the 2 per cent objective for more than a few months at a time.
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Indeed, the Fed has often been criticised for failing to react strongly enough to excess unemployment, while in effect setting a strict ceiling for price inflation in order to keep inflation expectations anchored at 2 per cent.
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This is certainly a fair description of how Chairman Bernanke has generally acted. He has been a longstanding supporter of inflation targets, and in January of this year, he persuaded the FOMC to adopt a formal long term objective of 2 per cent for PCE inflation. For several months thereafter, he appeared unsupportive of policy easing, in case his new inflation target would lose credibility at a time when actual inflation was rising.
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To be fair to the Chairman, he explicitly said when introducing the inflation target that the Fed would give equal weight to both sides of its dual mandate. The key sentences in his January press conference were the following:
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The Committee always treats its primary objectives of price stability and maximum employment symmetrically, and the stance of policy at any given time is determined by the size, social cost, and expected evolution of the deviations of each of the Committee’s policy objectives from its desired level. For example, if inflation did go above target by a modest amount, we would certainly try to get it back down to target, but if unemployment were very high, that would lead us to be more cautious and slower in returning to target..
In reply to the criticism he is now receiving from the Republican presidential campaign for pursuing an inflationary monetary strategy, Mr Bernanke could therefore argue that there has been no change in his overall approach to the Fed’s dual mandate, which is set for him by Congress. However, there is no doubt that he has shifted, within the dual mandate, to give much more precedence to short term deviations in unemployment from its sustainable rate than he did in January.
Why has he done this? It is not because the expected path for unemployment has worsened since January. Surprisingly, the path for unemployment in the FOMC’s September projections is almost exactly identical to that published in January, if not a little lower:
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Nor has there been any drop in the FOMC’s inflation projections, which might have given the Fed more scope to ease policy, relative to what was indicated earlier in 2012. It therefore follows that the only thing which can have changed is the FOMC’s interpretation of the seriousness of the unemployment problem. It now sees the weakness in the labour market as requiring much more urgent action than it thought as recently as a few months ago.
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The Chairman gave some clues about why he might have changed his thinking on this in his press conference on Thursday. He chose to open the press conference with the following words about unemployment:
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Millions have left the labor force–many of them doubtless because they have given up on finding suitable work. As the skills of the long-term unemployed atrophy and as their connections to the labor market wither, they may find it increasingly difficult to get good jobs to the detriment of our nation’s productive potential.
In economic terminology, therefore, he is worried about two things: 1) hysteresis, where unemployment gradually shifts from the cyclical variety to the structural variety, and consequently becomes immune to Fed action; and 2) the decline in the labour force participation rate, which he thinks is proceeding faster than can be explained by demographic factors alone. He is concerned that the size of the productive and available labour force is “downsizing” to fit the diminished size of the economy, in which case the shrunken scale of both may become irreversible. He has said this before, for example in this speech in March, but never as powerfully as he did last week.
Although this does not change the Fed’s fundamental interpretation of its dual mandate, it does change its short term “reaction function” as unemployment and inflation deviate from target. That probably means that QE3 will end up being much larger than either QE1 or QE2.
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This is a profound change which eventually could lead the Fed to tolerate inflation above 2 per cent, or even to flirt with a nominal GDP target. For good or ill, the markets will view Mr Bernanke in a different light from now on.
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