Jeremy Siegel, Ph.D. The Future for Investors

Ben Bernanke, Chairman of the Federal Reserve, will go before Congress next week to testify and respond to lawmakers’ questions on the state of monetary policy.  Since his appointment early last year, Bernanke has gone through two such appearances and has passed both with flying colors.  But this year promises to be different.  Barney Frank, the new Democratic Chairman of the House Financial Services Committee, has indicated that he intends to challenge Bernanke’s goal of elevating “price stability” to the forefront of the central bank’s priorities, claiming that the Fed Chairman is effectively demoting the mandated goal of “full employment.”

But this is not the case. Bernanke is doing the right thing by highlighting the importance of inflation targeting. If Barney Frank really wants to keep the economy healthy and the jobless rate low, there are good reasons why he must back away from this confrontation.

The Mandated Goals of the Fed

The current Congressional mandate to the Federal Reserve goes back nearly three decades.  In response to soaring inflation of the 1970s, the U.S. Congress passed the Full Employment and Balanced Growth Act in 1978, which required the Fed to pursue policies that promote “full employment, low long-term interest rates, and reasonable price stability.”  Since low long-term interest rates would not be possible without low inflation, this Act was interpreted as requiring the Fed to pursue the dual mandate of full employment and low inflation.

Because of a growing body of theoretical and empirical studies, economists concluded that monetary stimulus can influence employment only temporarily, but has a far more permanent impact on inflation. Targeting a high level of employment may instead bring about a higher and accelerating rate of inflation.

Inflationary Expectations

The works of Nobel Laureates Milton Friedman and Edmund Phelps showed that inflation, once started, soon generates “inflationary expectations.”  These expectations accelerate the inflationary process.  This is because inflationary expectations become incorporated into the price setting behavior of firms, labor and rental contracts, and interest rates.  Inflationary expectations can also depress the dollar on the international markets, raising the cost of all imported goods, including oil.

Once inflationary expectations take root, inflation becomes far more difficult to eradicate. To do so, the central bank must raise interest rates sharply, as they did in the early 1980s, which in turn precipitated a recession.  The end result is an unemployment rate higher than it would have been if inflation were stamped out early.

This view of how the economy works is accepted by virtually all central banks around the globe.  It was for these reasons that the world’s major central banks, such as the Bank of England, the Bank of Japan, and the European Central Bank rewrote their charters in recent years to elevate price stability as their number one goal.  They did this not because they believed that conquering inflation was more important than maintaining a strong economy, but because they knew that trying to target employment would reduce the inflation-fighting credentials of the central bank and increase inflationary expectations.

Elevating Price Stability

The Fed has not yet followed the lead of these other countries. Nearly a decade ago, Republican Jim Saxton from New Jersey introduced legislation, called the Price Stability Act, designed to put the Fed on the same footing as other central banks by elevating inflation as the primary target of Fed policymakers.

Although many at the Federal Reserve supported this legislation, Alan Greenspan, ironically, did not.  Greenspan stated that he could live with the “dual mandate” of high employment and stable prices since in order to achieve maximum employment it was first necessary to achieve price stability. He believed that the second mandate of full employment was actually predicated on achieving the first mandate of price stability. 

This was indeed a clever interpretation of the law. Alan Greenspan’s reputation as an inflation fighter was strong enough that he didn’t need targets to back his anti-inflationary credentials.  Bond traders around the world trusted that Greenspan would keep inflation low.

But individuals of Greenspan’s stature do not always lead the Fed.  By specifying a target range for inflation, Bernanke is trying to elevate the goals of the institution above those of any individual by establishing principles that represent the best practice in central banking. In January 2000, Bernanke and Frederic Mishkin, a professor at Columbia University who was subsequently named to Board of Governors, published an op-ed column in The Wall Street Journal stating that setting an inflation target would “depersonalize and institutionalize the Greenspan approach,” and increase the anti-inflation credentials of the Federal Reserve.

Bernanke’s position is correct. Maintaining anti-inflationary credentials is the most important aspect of central banking. By stating that it is the Federal Reserve’s intention to keep inflation low and within a specified range, Bernanke hopes to bring the Fed’s goals in line with those of other central banks and increase confidence in the Federal Reserve. Bernanke’s goals, if he is allowed to pursue them, will best achieve the very goals of full employment that Barney Franks and most other Americans believe is so important.