Friday, March 26, 2010

The Market Doesn't Believe the Fed

The Consumer Price Index for February was unchanged from January, and only 0.4% above August 2009, meaning inflation less than 1% at an annual rate the last six months. This is apparently not expected to continue, however, since the yield curve is steeply sloping and getting steeper.

A temporarily low inflation should not be the object of monetary policy. Recent price stability is due to weak demand that has nullified the massive increase in Federal Reserve credit, which is held mainly as excess reserves by banks.

In arguing against specific targets and their “false precision,” Chairman Greenspan said that the goal of “price stability is best thought of as an environment in which inflation is so low and stable over time that it does not materially enter into the decisions of households and firms” (2002). His successor, Ben Bernanke, reinforced this view in his first (2006) Monetary Policy Report to Congress.

Experience shows that low and stable inflation and inflation expectations [are] essential for strong and stable growth of output and employment.

Although he has said he has a plan to prevent the Fed's credit overhang from fueling future inflation, the market is skeptical. We do not see “stable inflation and inflation expectations.” The Fed announced a policy to reduce long rates (without changing its policy of low short rates), which was bound to be ineffective (see my blog of 10/4/09), but we have, not surprisingly, seen the opposite. The continued low short-rate policy (which the figure shows has become even more pronounced), and the Fed’s incredibility in general, has steepened the yield curve. This is abnormal for expansions, when short rates normally rise more than long rates.

The extent to which the Fed’s policy will retard recovery depends on expectations and realized inflation. If businesses and consumers are confident of future inflation, expected real long-term rates may be low and therefore encourage spending. In this case, expected inflation had better be realized or bankruptcies will result. The Fed will be pressured to produce expectations and possibly another bubble.

If high long rates are caused by uncertainty, current spending is reduced. We have no clue which way the Fed will jump. Its behavior the past few years has been unprecedented and gives no inkling of what’s in store.

“During the past two decades,” a monetary economist wrote earlier in the decade, “central bankers [have come to] agree that price stability is an important goal and that ‘credibility’ of policy and ‘transparency’ of its implementation are crucial to accomplishing that goal” (Green’s 2005 Review of Woodford 2005).

We wish. My April blog will discuss the Greenspan/Bernanke denial not only of personal responsibility but of the effects of monetary policy at all. Somehow, flying in the face of the history of central banks, which have nearly always operated through a short rate, monetary policy is no longer responsible for long rates, spending, or inflation.


Edward Green. 2005. “A Review of Interest and Prices by Michael Woodford,” J. Economic Literature, March.

Alan Greenspan, 2002. “Transparency in monetary policy,” Federal Reserve Bank of St. Louis Review, July/August.

Michael Woodford. 2003. Interest and Prices. Foundations of a Theory of Monetary Policy. Princeton Univ. Press.