What Can Ben Do?

| Sun Sep. 19, 2010 12:07 PM EDT

Tyler Cowen says today that the Fed has an easy way to boost the economy: just commit itself to an inflation rate of 3% over the next few years and people will open their checkbooks again. Personally, I'd prefer 4%. But either way, he's not very optimistic that this will happen:

If the Fed promises to keep increasing the money supply until prices rise by, say, 3 percent a year, people should eventually start spending. Otherwise, if they just held the money, it would be worth 3 percent less each year.

In a self-fulfilling prophecy, the Fed could stimulate spending and the economy, and at no cost to the Treasury. Of course, if no one believes the Fed’s commitment to price inflation, spending and employment will not go up. The plan will fail, and people will view their skepticism as vindicated.

In other words, one of our economic problems can be solved, but only if we are willing to believe it can.....Sadly, although [Ben] Bernanke clearly understands the problem, the Fed hasn’t been acting with much conviction. This is understandable, because if the Fed announces a commitment to a higher inflation target but fails to establish its credibility, it will have shown impotence.

....Part of the credibility problem stems from the political environment, especially in Congress. Imagine the day after the announcement of a plan for 3 percent inflation. Older people, creditors and workers on fixed incomes — all connected to powerful lobbies — would start to complain. Republicans would wonder whether they had found a new issue on which to campaign, namely, opposition to inflation. And Democrats would worry about what position to take. Presidents of some regional Fed banks would probably oppose the policy publicly.

It's not clear, of course, if (a) Bernanke agrees that we should target higher inflation but hasn't been able to persuade the rest of his colleagues, or (b) he's part of the problem. Option A is plausible, but I've read nothing suggesting that Bernanke has even mooted higher inflation targeting. How likely is it that he could do that with any vigor and not have word leak out?

Not very, I think. So I'd conclude either that Bernanke himself isn't on board with this or that the political climate is so obviously hostile that he knows it's hopeless to try. Neither one is very reassuring news.

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