Two months after Bernanke's unexpected trip to Japan failed to unleash the "helicopter money" many expected his visit to the BOJ would deliver, Bernanke is back with another shocking policy appeal, this time not as a result of a trip to the Pacific Rim, but in a post on his Brookings Institute blog, titled "Modifying the Fed’s policy framework: Does a higher inflation target beat negative interest rates?"
The post, when one cuts out the noise, is nothing short of praise for NIRP as an alternative to inflation targeting, and a strong suggestion that it should be implemented in the US if and when the US economy slides into recession next.
Bernanke starts off by saying that while much of the recent "shift" in unconventional thinking has been to advocate a higher inflation target, he believes that negative rates present an as good if not better option. The former Fed chairman says that "when the next recession arrives, there may be limited room for the interest-rate cuts that have traditionally been central banks’ primary tool for sustaining employment and keeping inflation near target. That concerning possibility has led to calls for a new monetary policy framework, including by Fed insiders like John Williams, president of the San Francisco Fed. In particular, Williams has joined Olivier Blanchard and other prominent economists in proposing that the Fed consider raising its target for inflation, currently 2 percent. If the Fed targeted a higher average level of inflation, the reasoning goes, nominal interest rates would also tend to be higher, leaving more room for rate cuts when needed. "
Here Bernanke expresses his surprise that some of his "erudite", Ivy-educated peers have already dismissed the use of negative rates in the future. We assume he has purposefully ignored the repeated, ever louder complaints by Deutsche Bank and Credit Suisse as well as virtually every pension fund in the world, lamenting that they are slowly going out of business due to the twilight zone of unorthodox monetary policy:
Some advocates of a higher inflation target have been dismissive of the use of negative short-term interest rates, an alternative means of increasing “space” for monetary easing. For example, in a recent interview in which he advocated reconsideration of the Fed’s inflation target, Williams said: “Negative rates are still at the bottom of the stack in terms of net effectiveness.” Williams’s colleague on the Federal Open Market Committee, Eric Rosengren, also has suggested that the Fed may need to set higher inflation targets in the future while asserting that negative rates should be viewed as a last resort. My sense is that Williams’s and Rosengren’s negative view of negative rates is broadly shared on the FOMC.
So before the last rites of NIRP are read, here comes Blackhawk "Chairsatan" Ben to try to rekindle the possibility of negative rates in the US.
As I explain below, negative rates and higher inflation targets can be viewed as alternative methods for pushing the real interest rate further below zero. In that context, I am puzzled by the apparently strong preference for a higher inflation target over negative rates, at least based on what we know now. Yes, negative interest rates raise a variety of practical problems, as well as political and communications issues, but so does a higher inflation target.... I argue that it’s premature for policymakers to emphasize the option of raising the inflation target over the use of negative rates. Pending further study about the costs and benefits of both approaches, we should remain agnostic about whether either or both should be part of the Fed’s policy framework.
A quick skim of his post reveals the fallacy inherent in his thinking, namely that punishing savers either with increasingly more negative rates or progressively higher inflation goals, will force them to rush out and spend.
Economic theory suggests that aggregate demand (consumption and investment) responds to the real rate of interest, which is the nominal (market) interest rate minus the public’s expected rate of inflation. As I noted in my earlier post on negative rates, the Fed has routinely set the real federal funds rate at negative levels (i.e., with the nominal funds rate below inflation) to fight recessions. However, with the inflation target at its current level of 2 percent, and assuming that the Fed does not set its policy rate lower than zero, the Fed cannot reduce the real policy rate below -2 percent, i.e. a zero nominal rate less 2 percent expected inflation. History, including the experience of the past few years, suggests that—in the absence of a robust fiscal response—that may not be enough to deal with a bad recession. To reduce the real policy rate further, the Fed would either have to lower the nominal interest rate into negative territory, raise expected inflation (by raising the inflation target), or both. Since negative nominal rates and a higher inflation target both serve to reduce the lower (negative) bound on the real interest rate achievable by monetary policy, they are to some extent substitutes.
What Bernanke spends zero time on is the practical consequences of NIRP, which as we previewed one years ago, and which even the WSJ now admits is the case, forces savers to save even more, since they know they can't rely on their cash to generate interest income, forcing them to limit their spending further as they prepare for retirement in a world in which saving is not only not rewarded but punished, and where real wages continues to decline year after year. Of course, one has to be a Princeton economist living in an ivory tower not to grasp this most simple observation.
In any event, to make the case for NIRP, Bernanke lays out several factors why he thinks negative rates are preferable to inflation targeting, such as:
- "Ease of implementation": "Negative interest rates are easy to implement. In practice, central banks in Europe and Japan have imposed negative short-term rates by deciding to charge (rather than pay) interest on bank reserves, an action that is clear, concrete, and essentially instantaneous"... "In contrast, while the Fed could announce at any time that it is raising its inflation target, the announcement would not increase the Fed’s ability to lower the real interest rate unless the public’s inflation expectations changed accordingly"... "The public might also have reasonable doubts about the Fed’s ability to reach the higher target or about the willingness of the Congress or future Fed policymakers to support a higher inflation goal, both of which would reduce the credibility of the new target and thus its ability to influence expectations."
- "Costs and side effects": "negative rates can create problems for money market funds, banks, and other financial institutions, costs that would have to be managed if rates remained negative for very long. These concerns are legitimate, since effective transmission of monetary policy requires a properly functioning banking and financial system." However, he explains that "there are also means by which central banks can limit the effects of negative rates on bank profits—by charging a negative rate only on a portion of bank reserves, for example, as the Bank of Japan has done."
On the other hand, "higher inflation has costs of its own, of course, including making economic planning more difficult and impeding the functioning of markets. Some recent research suggests that these costs are smaller than we thought , particularly at comparatively modest inflation rates. Higher inflation may also bring with it financial stability risks, including distortions it creates in tax and accounting systems and the fact that an unexpected increase in inflation would impose capital losses on holders of long-term bonds, including banks, insurance companies, and pension funds."
At this point a vague image emerges why Bernanke wants NIRP over higher inflation targeting: while NIRP is an "ice age" equivalent for banks, it does not shock the system into a sharp selloff. On the other hand, as the recent days have shown, even the smallest hint of a spike in forward inflation, leads to dramatic selloffs across the bond curve, which immediately transmits over to equities and other risk assets. In other words, all Bernanke is likely petitioning with his latest post, is to prevent a market rout.
- "Distributional effects", or who suffers (the most) from the Fed's ongoing lunacy: "The most direct costs of higher inflation are borne by holders of cash, and, again, with a higher inflation target those costs would be experienced at all times, not just during recessions. More generally, less wealthy people may find it more difficult to protect themselves from inflation. In contrast, negative rates would probably most affect more financially sophisticated and market-sensitive firms and households. In particular, banks would probably not pass on negative rates to small depositors, with whom they want to maintain profitable long-run relationships, but instead would more likely impose negative rates on “hot money” investors who place less value on longer-term relationships."
Going back to our point above, Bernanke then explicitly warns that "the transition to a higher level of inflation would hurt holders of bonds and other non-indexed assets while providing a windfall for debtors, including mortgage borrowers. In the medium term, nominal returns to saving (including the investments of pension funds, life insurance companies, etc.) would be higher with a higher inflation target, but the real (net of inflation) returns received by savers would be similar under either regime."
- "Political risks" - we found this point most interesting, because this is the first discussion by Bernanke in an semi-official document of what the angry, populist response to years of Fed failure will look like. For now, he is mostly focused on public anger falling on Congress (even though the Marriner Eccles building is so close). What he says is that "both negative rates and a higher inflation target would be politically unpopular, possibly leading to reduced support for the policies of the central bank and for its independence. In particular, as already noted, the credibility of a higher inflation target could be reduced if political support for it were seen to be tenuous. Political viability is thus an important concern in judging these policy options."
What Bernanke seems to believe is that while both are clearly unpopular, the public's distate for NIRP is less than that to soaring inflation: "in the political sphere, the fact that negative rates would be temporary and deployed only during severely adverse economic conditions would be an advantage. Like quantitative easing, which was also unpopular in many quarters, a period of negative rates would probably be tolerated by politicians if properly motivated and explained. We have some evidence on this point: Negative rates are disliked by many in Europe and Japan but central banks have been willing and able to use them without facing high political costs, at least so far."
Alternatively, "a higher inflation target would be a permanent, or at least very long-lasting change, not restricted to an emergency; and it would raise questions about the flexibility of the Fed’s legal mandate to achieve price stability. It thus might need explicit approval or at least some sort of review from Congress. A possibility, recently proposed by a comprehensive study on monetary policy options, would be to set up a commission to assess potential changes in the Fed’s policy regime and to report to Congress and the public."
And here comes what may be a very prophetic warning by Bernanke, inasmuch as his intention is to push for NIRP, namely that if and when inflation goes out of hand, that will be final straw for the Fed in its current format, and even Keynesian economics:
In the United States, as in Europe, there is a substantial element of public opinion (well represented in legislatures and even in the central banks themselves) that holds that central banks should concern themselves only with inflation, and that efforts to use monetary policy to stabilize employment are illegitimate or impractical. These views have manifested as opposition to the Fed’s accommodative policies in recent years, and even in legislative efforts to eliminate the employment part of the Fed’s dual mandate. Holders of this perspective would be unimpressed by the cost-benefit analyses of the Keynesian proponents of a higher inflation target. To the contrary, they would strongly oppose choosing higher inflation in order to give the Fed more room to respond to employment fluctuations, and indeed might seek a lower target. In their efforts they would be aided by the public’s money illusion (the tendency to confuse general inflation in both wages and prices with changes in real wages). Whatever the abstract merits of a higher inflation target, if it is not politically achievable then it is of no benefit.
To summarize all of the above, Bernanke has emerged as a big supporter of NIRP and is quite hostile to the incipient line of thought at the Fed and elsewhere, according to which the next monetary policy to be attempted - ahead of or during recession - should be 4% (or more) inflation targeting.
This is his conclusion:
It would be extremely helpful if central banks could count on other policymakers, particularly fiscal policymakers, to take on some of the burden of stabilizing the economy during the next recession. Since that can’t be assured, and since the current low-interest-rate environment may persist, there are good reasons for the Fed and other central bankers to consider changes in their policy frameworks. The option of raising the inflation target should be part of that discussion. But, as I have argued in this post, it is premature to rule out alternative or potentially complementary approaches, including the possibility of using negative interest rates.
Bernanke may - or may not, if the recent helicopter money snub in Japan is any indication - get his wish, but NIRP is most likely irrelevant: as we reported three weeks ago in "Fed Admits Another $4 Trillion In QE Will Be Needed To Offset An "Economic Shock", what happens in the next recession is neither NIRP nor inflation targeting but another doubling of the Fed's balance sheet. In other words, while economists will argue what is the appropriate monetary response to the next recession, when by now it is clear that any central bank intervention will only make the problem worse and the underlying problem is not the business cycle but the Fed itself which should be eradicated and abolished immediately to stop the perpetuation of unprecedented asset bubbles, the Fed is already strategizing how to inject another $4 trillion in the stock market and to bring the Fed-enabled LBO of the equity market to a successful, for the 0.01%, conclusion.