Good monetary policy raises inflation during recessions

Fed chair Ben Bernanke thinks he had the best record on inflation since WWII because he held inflation down so low, but Moneybox argued that he actually had the worst because higher inflation would have been beneficial to the economic recovery:

Testifying before Congress recently, Ben Bernanke bragged, “my inflation record is the best of any Federal Reserve chairman in the postwar period, or at least one of the best, about 2 percent average inflation.”

Catherine Rampell’s numbers show that Bernanke has, in fact, delivered the lowest inflation of any postwar Fed chair, coming in at an average of 2 percent. On the other hand, Floyd Norris notes that unemployment under Bernanke has been second-highest of any postwar Federal Reserve chairman. Now if you ignore the “postwar” qualifier, the picture looks different. Several Depression-era Fed chairs had less inflation and more unemployment than Bernanke. And putting those Depression-era bankers into the mix serves to highlight how absurd Bernanke’s boast is. No sensible person would look at America’s economic performance in the 1929-1933 period and say “man, they did a great job of fighting inflation.”

It is true that inflation was very low—indeed, negative—for most of this period, but that simply goes to show they were doing a terrible job.

Suppose Ben Bernanke resolved to deliver enough aggregate demand to get the inflation rate up to its Greenspan-era average of 2.6 percent. Unless you believe there is literally zero slack or excess capacity in the economy, that would create some extra jobs and real growth. And was inflation so terrible in the Greenspan years? Nope. At the time, Greenspan-level inflation was considered a historic victory in the war on inflation.

During the years of slow recovery following the Great Recession there were many prominent academics calling for higher inflation from both the political right and the left, but almost nobody at the Fed was voicing that concern and that is the only place that really matters.  It didn’t happen.

Many prominent people on Wall Street were opposed to higher inflation and that opinion got more sway at the Fed because the Fed is biased in favor of the interests of Wall StreetMatthew Yglesias explained that Wall-Street also convinced Washington politicians to favor low inflation:

I regularly give Ben Bernanke a hard time for the excessively tight monetary policy he’s run at the Federal Reserve… But in Bernanke’s defense I should say that the really striking thing about his appearance is the utter and total lack of influence of dovish monetary policy views on Capitol Hill.

If you read a lot of economics coverage on the Internet, you’ll be struck by the amazing success of “dovish” monetary policy views. I’ve been pushing them here at Slate, Ryan Avent pushes them at the Economist, Matt O’Brien pushes them at The Atlantic, Tim Fernholz and Miles Kimball push them at Quartz, Josh Barro and the Stevenson/Wolfers team push them at Bloomberg, Ramesh Ponnuru pushes them at National Review, Ezra Klein pushes them on Wonkblog, Paul Krugman and Tyler Cowen have both pushed them in the New York Times, etc. It’s not like an overwhelming consensus or anything, but normally a political stance with this much representation in the media could find at least one significant politician to stand up for it. But while we have Obama’s former Council of Economic Advisers Chair and the chief economist at Goldman Sachs on our side, we seem to have zero members of congress.

This is not an excuse for the Fed’s too-tight policies …but it’s probably a reason for it. If nobody in congress objects to crucifying mankind upon a cross of [low inflation] targeting then realistically it seems unlikely to stop.

Inflation was too high in the 1970s and early 1980s because Fed economists had a poor understanding of when inflation is too high and how to control it.  Today inflation is too low because Fed economists have a poor understanding of the costs of inflation that is too low and how to raise it.  In some ways, we are suffering from the mirror image of the problems of the 1970s.  

Lowering inflation is simple.  Just restrict the money supply and clearly communicate the plan to shape public expectations.  Raising inflation is also simple.  Just expand the money supply and communicate a clear plan.  Today it seems amazing that economists did not understand this in the 1970s when inflation was too high and someday it will seem amazing that many prominent economists do not understand this today.

Some economists (including a Fed Vice President) are still puzzled why inflation did not explode when the Fed quadrupled the monetary base, but the reason should be obvious.  The rise in the monetary base was almost entirely Fed cannot raise inflation merely by expanding bank reserves because reserves are not money.  The monetary base is equal to bank reserves plus physical currency.  Only the physical currency that is in circulation is ever part of the money supply.  Here is the graph of how much the Fed expanded the part of the monetary base that is used as money:

The only part of the monetary base that is used as money did not explode at all and for this reason it should not be surprising that the explosion of the monetary base failed to ignite inflation. The “monetary base” is poorly named because it is mostly bank reserves which is not money.

But some economists have interpreted this as evidence that the Fed is powerless to raise inflation!  That is a weird claim since every 2-bit, 3rd-world central bank has not only been able to increase inflation, but generally had problems with too much inflation.  If they can do it, the much more powerful and intelligent Fed can too.  The same economists claimed that it was impossible for Japan’s central bank to raise inflation, but Japan succeeded by committing to doing as much quantitative easing as it would take to raise inflation to the target level.  The US Fed hasn’t even said that it wants higher inflation, much less taken specific actions to accomplish it.  If you can’t even find the will to say it, you probably can’t do it.

Japan’s move was big news because it was the first time in history that a central bank announced that is was deliberately trying to increase inflation.  Central banks often accidentally increase inflation due to attempts to stimulate the economy, but it always been an unintended byproduct and is often unwanted.
There are many things that the Fed could do to raise inflation if it wanted to.  The US Fed could do more quantitative easing, cut interest rates on bank reserves, or even do some helicopter drops.  Even raising core inflation to a 2% average would be better for stimulating the economy.   The problem is a lack of will.  The first step would be for the Fed to decide that it wants to raise inflation and communicate that intention.  If the Fed doesn’t want more inflation, then it really is impossible to get.
Posted in Macro

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