BERNANKE AT THE CREATION / THE WALL STREET JOURNAL REVIEW & OUTLOOK ( HIGHLY RECOMMENDED READING )

REVIEW & OUTLOOK

JUNE 23, 2009.

Ben Bernanke vs. The Journal on Inflation

Bernanke at the Creation

What the Fed Chairman said at the onset of the credit bubble, and the lesson for today

The Federal Reserve's Open Market Committee meets today, amid a debate over how and when to remove the flood of liquidity it has poured into the economy in the last 18 months. Fed officials say not to worry, they're as vigilant about inflation as ever -- which is itself a reason to worry. We've all seen this movie before, when the Fed's failure to act in time gave birth to the housing bubble and credit mania that eventually led to panic and today's recession. Will it make the same mistake now?

We remember that 2003 debate because it turns out we played a part in it. The Fed recently released the transcripts of its 2003 FOMC meetings, and what a surprise to find a Journal editorial the subject of an insider rebuttal from none other than Ben Bernanke, then a Fed Governor and now Chairman. We had run an editorial on monetary policy on the same day as the Dec. 9, 2003 FOMC meeting, and Mr. Bernanke clearly didn't take well to our warning about "Speed Demons at the Fed."

We reprint nearby both Mr. Bernanke's comments and our editorial from that day. Readers can judge who got the better of the argument, but far more important is what Mr. Bernanke's reasoning tells us about the Fed today. Our guess is that it won't reassure holders of dollar assets.

* * *
Recall that by the end of 2003 the economy was well into recovery. Third quarter GDP growth had clocked in at 8.2% (later restated to 7.5%), and growth in all of 2004 would be 3.6%. The Bush tax cuts had passed in late May, providing a fiscal boost, and a month later the Fed had cut its fed funds rate to 1% and would hold it there for a year. Yet by December Mr. Bernanke was still giving speeches fretting about "deflation," even as commodity prices were rising and growth was kicking into higher gear. Thus our Dec. 9 warning, the first of many by us and others.

Mr. Bernanke's FOMC remarks that day are especially revealing about how he thinks about monetary policy. In particular, he dismisses any link between commodity price increases and future inflation. He cites a study by a Fed economist claiming to find little connection between "materials" prices and overall inflation. Yet the price of oil was already rising sharply at the time, and it would keep rising as the Fed maintained negative real interest rates for many more months. This was a bad mistake.

Rising gas and food prices didn't show up in the Fed's "core" inflation measurements, but they sure did wallop U.S. consumers this decade. It's one reason Americans never felt great about the expansion. The soaring price of oil also contributed to the housing bubble by transferring wealth from U.S. consumers to oil exporters such as the Gulf States and Russia, which in turn recycled those petrodollars into U.S. Treasurys and mortgage-backed securities. By ignoring commodity prices, the Fed fueled the housing boom.

It's also striking how dismissive Mr. Bernanke is of the declining dollar. We'd have thought the greenback's value would be the Fed's paramount concern, given its mandate to keep prices stable. Yet Mr. Bernanke declared that "large movements of the dollar against major currencies tend to translate into smaller movements against the U.S. trade-weighted basket of currencies and into still smaller effects on import prices because of imperfect pass-throughs." Translation: Exchange-rate fluctuations aren't the Fed's problem, no matter how disruptive their effect on trade and capital flows.

Instead of following these actual prices, Mr. Bernanke's main monetary policy guide is something called "the output gap." This is the difference between actual GDP growth and the level of "potential output," or how fast the economy can grow when it's at full capacity. The problem with this guide is that it relies heavily on labor costs and the jobless rate. And because job creation tends to lag economic recovery, these signals tend to flash yellow long after price pressures or asset bubbles have begun to build.

All of this is relevant today because there is no evidence that Mr. Bernanke and his Fed colleagues have changed their thinking. They still ignore a falling dollar and rising commodity prices, even as oil has climbed to $70 a barrel from $40 six months ago. They also continue to be slaves to the output gap, which means they are unlikely even to begin to tighten as long as the jobless rate remains high. With that rate now at 9.4% and likely to rise, the monetary spigots will probably remain wide open for a long time to come.

We think the Fed made the right call last fall when it eased dramatically in the heat of the panic. The financial shock had caused a decline in the velocity of money, and the Fed needed to boost the supply of money to prevent a genuine deflation. The recession this time is far deeper than in 2001-2002, so there is also a case to be made for erring on the side of being slower to tighten.

But this time the Fed has also gone to greater easing lengths than it ever has, taking short-rates nearly to zero and making direct purchases of mortgage securities and even Treasuries. These are extraordinary acts that push the Fed deeply into fiscal policy, credit allocation and directly monetizing Treasury debt. Combined with the 2003-2005 mistake, they have also raised grave doubts about the Fed's credibility and independence.

* * *
Mr. Bernanke will need political courage that we haven't seen since Paul Volcker was Chairman in order to exit from all of these efforts in time to prevent another bubble or broader inflation. It also wouldn't hurt if the Fed chief looks back with some humility on his intellectual certainty, circa 2003, and analyzes why he was so wrong.

Copyright 2009 Dow Jones & Company, Inc. All Rights Reserved