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Here’s The 2004 Speech That Explains Why Bernanke Won’t Ease Further


Paul Krugman thinks that Fed chairman Ben Bernanke is screwing up because he has too strong of an anti-inflation bias.

But it seems pretty clear to me that Krugman just doesn’t understand Bernanke’s thinking when it comes to inflation expectations.

Let’s start with Krugman.

A further thought on Bernanke’s press conference, not too different from what Yglesias says, but I’ll put in in economese rather than English.

So here it is: it turns out that the Fed’s 2 percent target for core inflation is not a target, it’s an upper bound.

If you really think that around 2 percent inflation is right (I’d prefer 4, but that’s a different issue), you’re supposed to view 1 percent inflation as being just as bad as 3 percent; in a situation in which inflation is below the target rate, you’re supposed to see a rise in that rate as a good thing. And correspondingly, if you’re where we are now, with below target core inflation and high unemployment, all lights should be flashing green for expansion.

Instead, however, it’s clear that below-target inflation is considered no big deal, but that the Fed is extremely averse to seeing inflation rise above target, even temporarily.

This is really bad, especially when you combine it with the strong evidence that slight positive inflation can be consistent with a persistently depressed economy.

Here’s Yglesias’s version of that argument:

Imagine you’re teaching a kid archery. You tell him to aim for the bullseye. But you also warn him that if the arrow goes to the left of the bullseye, he’s going to be in big trouble while if it goes to the right of the bullseye you won’t really mind. Well, naturally the kid’s never going to hit the bullseye. He’s going to shoot too far the right. And that’s the Fed right now.

When you put it in those terms, Bernanke’s refusal to engage in further easing while unemployment is above target and inflation is below is a bit mysterious. Krugman thinks it is evidence that the Fed has been “bullied into ineffectuality.”

But this bias is not some mistake Bernanke is accidentally making. In a speech he gave in 2004—back before he was named Fed chairman—Bernanke explained why this anti-inflationary bias is required to fight off stagflation.

When people are learning about the inflation process, an increase in inflation that would be only temporary and would leave expectations unaffected in a rational expectations world, may instead lead the public to infer that the long-run average rate of inflation is higher than previously thought. The rise in the public's inflation expectations affects wage- and price-setting and other economic decisions and thus raises actual inflation. In a vicious cycle, the higher rate of realized inflation further increases inflation expectations, forcing the central bank to tighten policy. The result is inflation that is unnecessarily high and output that is unnecessarily low.

In other words, even a short period of inflation can set off an inflation panic—an irrational expectation of higher inflation. And the inflation panic leads directly into stagflation.

“In general…the central bank's optimal policy involves exerting a tighter control on inflation than it might otherwise exert, to avoid the possibility that inflation expectations will drift randomly higher (or lower),” Bernanke said.

From Bernanke’s perspective, then, Krugman is just wrong. If you’re targeting 2 percent inflation, getting 1 percent inflation not just as bad as getting 3 percent. The two sides of the bullseye are not equivalent.

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  • Jeff Cox is finance editor for CNBC.com.

  • Lawrence Develingne

    Lawrence Delevingne is the ‘Big Money’ enterprise reporter for CNBC.com and NetNet.

  • Stephanie Landsman is one of the producers of "Fast Money."

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