fed chair bernanke: monetary policy by the new kid on the block larry deboer agricultural economics...

Fed Chair Bernanke: Monetary Policy by the New Kid on the Block

Larry DeBoerAgricultural Economics

Purdue UniversityOctober 19, 2006

Benjamin Bernanke Born December 15, 1953 BA Economics, Harvard, 1975 PhD Economics, M.I.T., 1979 Princeton Economics

Professor, 1985-present Federal Reserve Board

Member, 2002-05 Chair, President’s Council on

Economic Advisors, 2005-06

Benjamin Bernanke

Became chair of Federal Reserve Board, February 1, 2006. Term as chair expires in January 2010; Term on Board runs through 2020.

Bernanke and Monetary Policy

What can we expect?

Bernanke and Monetary Policy

Bernanke on:– The Great Depression– The Great Inflation– The Great Moderation

Quotations from Chairman Bernanke

As first pointed out by the economist Irving Fisher, interest rates will tend to move in tandem

with changes in expected inflation, as lenders require compensation

for the loss in purchasing power of their principal over the period of

the loan.

Bernanke speech, 2/24/06

Real Interest Rates

Lenders want to make a profit by collecting interest

When there is inflation, the money paid back by borrowers is worth less in purchasing power

Inflation must be accounted for in the interest rate

Real Interest Rates

Approximate Formula:

Real interest rate =

Nominal interest rate – Expected inflation

If you want to understand geology, study earthquakes. If you want to understand economics, study the

biggest calamity to hit the U.S. and world economies.

Wall Street Journal, Dec. 7, 2005


Why did the Federal Reserve raise interest rates in 1928? The principal reason was the

Fed's ongoing concern about speculation on Wall Street. . . .When the Fed's

attempts to persuade banks not to lend for speculative purposes proved ineffective, Fed officials decided to dissuade lending directly by raising the policy interest rate.

Bernanke Speech, 3/2/04


Dow Jones Industrial Average, Monthly, 1921-1940

Peak around 400

Trough around 50

Stocks lose almost 90%of their value in 3 years.

October 1929,360 to 210, 42% loss.300%

rise in 5 years.

Fed reacts to stock speculation

To stabilize the dollar [in 1931], the Fed once again raised interest rates sharply, on the view that currency speculators would be less willing to liquidate dollar assets if they could earn a higher rate of return on them. . . . Once again the Fed had chosen to tighten monetary policy despite the fact that macroeconomic conditions--including an accelerating decline in output, prices,

and the money supply--seemed to demand policy ease.



To prevent a gold drain

Other officials, noting among other indicators the very low level of nominal interest rates, concluded that monetary

policy was in fact already quite easy and that no more should be done. These

policymakers did not appear to appreciate that, even though nominal interest rates

were very low, the ongoing deflation meant that the real cost of borrowing was

very high because any loans would have to be repaid in dollars of much greater value.



Two years of inaction

90% drop in Investment1929-32

As depositor fears about the health of banks grew, runs on banks became increasingly common. A series of banking panics spread across the

country, often affecting all the banks in a major city or even an entire region of the country. . . . Fed officials decided not to intervene in the banking crisis,

contributing once again to the precipitous fall in the money supply.



One Third of all banks failed, 1930-33.

A bank run during the Great Depression

The Fed’s Failures during the Great Depression

Tried to stop stock market speculation with interest rate increases

Tried to prop up the dying gold standard with interest rate increases

Misinterpreted low nominal interest rates as expansionary, failed to reduce real interest rates

Failed to act as a lender of last resort, allowing banking system to collapse

Pro-cyclical policy: High real interest

Pro-cyclical policy: High real interest

rates during a depressionrates during a depression

Fed Chair Ben Bernanke to Economist Milton Friedman

Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.

Wall Street Journal, Dec. 7, 2005


Quotations from Chairman BernankeThirty years ago, the public's expectations of inflation were not well anchored. With little confidence that the Fed would keep inflation low and stable, the public at that time reacted to the oil price increases by anticipating that inflation would rise still further. A destabilizing wage-price spiral ensued as firms and workers competed to

"keep up" with inflation.



During the 1960s and early 1970s, some policymakers appeared to believe that price stability and high employment were substitutes, not complements.

Specifically, some influential voices of the time argued that, by accepting higher

inflation, policymakers could bring about a permanently lower rate of

unemployment.

Arthur Okun, Chairman, Council of Economic Advisors, 1968-69

You could go down that curve just as you went up

the curve. Why can’t we get back to where we were in 1965, the good old days?



The idea of the permanent tradeoff did not go unchallenged, however. In 1967,

economists Milton Friedman and Edmund Phelps independently produced

influential critiques of this view.

Edmund PhelpsNobel Prize in Economics, 2006



Suppose that firms and workers set nominal wages once a year but that, sometime during

the year, the prices of firms' output rise unexpectedly as a result of stronger-than-

expected demand. The combination of higher prices for their output and fixed

nominal wages would raise the profitability of increasing production; thus, assuming

that more workers are available at the previously fixed wage, firms would respond

to the rise in prices by adding workers.



However, this logic applies only during the period in which wages and workers' expectations of inflation are fixed.

. . . Higher inflation expectations would in turn lead workers to bargain for

commensurate raises in nominal wages to preserve the real value of their earnings.

With nominal wages rising as well as prices, firms would no longer have an incentive to hire additional workers, and employment

would return to its normal level.



The inflationary policies of the 1960s led not to permanently lower unemployment, as the permanent-

tradeoff theory predicted, but instead to persistently higher inflation with no improvement in unemployment.

1%1%

3%3%

11%11%

No long-run inflation-No long-run inflation-

unemployment tradeoffunemployment tradeoff

5.7%5.7%



The Fed, attempting to gain control of the deteriorating inflation situation,

raised interest rates sharply; however, initially at least, these increases proved

insufficient to control inflation or inflation expectations, and they added substantially to the volatility of output

and employment.

“Behind the Curve”



There was, until the end of the 1970s, little appetite for taking the actions necessary to reduce inflation. For one thing, economists

and policymakers recognized that reversing the rise in inflation expectations that had occurred during the 1970s could take time and that, during the process, the nation could suffer ultimately transitory

but still-serious increases in unemployment.



Federal Reserve Board Chairman Paul Volcker embarked on his campaign to

break the back of U.S. inflation in October 1979. . . . Volcker dismissed the notion that lowering inflation meant accepting permanently higher unemployment and suggested instead that the reverse was

more likely to be the case.

The Fed’s Failures during the Great Inflation

Thought there was a permanent tradeoff between inflation and unemployment

Allowed inflationary expectations and a wage-price spiral to develop

Fell “behind the curve,” increasing nominal interest rates but not real interest rates as inflation increased

To get rid of inflationary expectations, required high real interest rates and a long recession

Pro-cyclical policy: low real interest

Pro-cyclical policy: low real interest

rates during inflationrates during inflation


Quotations from Chairman BernankeDuring the past twenty years or so, in the

United States and other industrial countries the volatility of both inflation and output

have significantly decreased--a phenomenon known to economists as the

Great Moderation.


Quotations from Chairman BernankeSubsequent events demonstrate clear

benefits from the tenacity of the Fed under Greenspan. Lower inflation has been

accompanied by inflation expectations that are not only lower but better anchored, so

far as we can tell. Most striking, Greenspan's tenure aligns closely with the

Great Moderation, the reduction in economic volatility. . . . developments that had many sources, no doubt, but that were

supported, in my view, by monetary stability.


Quotations from Chairman BernankeThe key to explaining why price stability

promotes stability in both output and employment is the realization that, when

inflation itself is well-controlled, then the public's expectations of inflation will

also be low and stable. In a virtuous circle, stable inflation expectations help the central bank to keep inflation low

even as it retains substantial freedom to respond to disturbances to the broader

economy.


Quotations from Chairman BernankeOf course, the relatively benign state

of inflation expectations we enjoy today has not come automatically.

The anchoring of inflation expectations in a narrow range has

been the product of Fed policies that have kept actual inflation low in

recent years, clear communication of those policies, and an institutional

commitment to price stability.

The Fed’s Successes during the Great Moderation

Holding inflation low for more than twenty years. “Anchors” inflationary expectations, develops

public confidence that inflation will remain low Allow quick response to recessions with real

interest rate cuts Requires anticipating inflation increases with real

interest rate hikes

counter-cyclical policy: low real counter-cyclical policy: low real

interest rates in recession; high real

interest rates in recession; high real

interest rates in inflationinterest rates in inflation



Some important lessons emerge from the story. One lesson is that ideas are

critical. [But] perhaps the most important lesson of all is that price

stability should be a key objective of monetary policy.

What can we expect?

fed chair bernanke: monetary policy by the new kid on the block larry deboer agricultural economics...

Documents

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great moderation slide

bernanke speech

stock speculation slide

gold drain slide