Ben Bernanke vs John Taylor …again

Though Krugman vs others dominates the economics debates, some others are as interesting.

John Taylor has been highly critical of Fed and overall government policy for creating this massive recession. He has said in numerous papers (see this) that Fed kept policy rates much lower in 2003-06 than what his Taylor rule predicted. Bernanke (and Kohn) gave a stirring speech saying Taylor rule does not work in real-time policy.  Taylor responded to this saying Fed’s forecasts of inflation were too low etc (read further for details)

Taking the debate further, Bernanke wrote an Op-ed defending Fed’s move to pass another round of quant easing (QE2).

low and falling inflation indicate that the economy has considerable spare capacity, implying that there is scope for monetary policy to support further gains in employment without risking economic overheating. The FOMC decided this week that, with unemployment high and inflation very low, further support to the economy is needed. With short-term interest rates already about as low as they can go, the FOMC agreed to deliver that support by purchasing additional longer-term securities, as it did in 2008 and 2009. The FOMC intends to buy an additional $600 billion of longer-term Treasury securities by mid-2011 and will continue to reinvest repayments of principal on its holdings of securities, as it has been doing since August.

This approach eased financial conditions in the past and, so far, looks to be effective again. Stock prices rose and long-term interest rates fell when investors began to anticipate the most recent action. Easier financial conditions will promote economic growth. For example, lower mortgage rates will make housing more affordable and allow more homeowners to refinance. Lower corporate bond rates will encourage investment. And higher stock prices will boost consumer wealth and help increase confidence, which can also spur spending. Increased spending will lead to higher incomes and profits that, in a virtuous circle, will further support economic expansion.

To this, Taylor responds saying Fed cannot say asset prices have risen on the expectations of QE alone:

How can one determine whether stock prices rose and long-term interest rates fell in anticipation of QE2? Obviously it is very difficult because many other things affect stock and bond markets, and one can never know for sure, but the data presented in the following charts raise serious doubts that such anticipation effects were either substantial or sustainable.

He looks at event studies and looks at changes in asset prices and exchange rates. He says we cannot give all credit to Fed:

Ben Bernanke’s August 27 Jackson Hole speech was helpful in this regard because it undid the damage of the August 10 meeting, as I argued at the time, by presenting a transparent framework for making decisions and conveying the image of a more functional FOMC than portrayed, for example, in Hilsenrath’s article. So in my view, the consistent story is that the August stock market dip was Fed-induced and its reversal was also Fed-induced. In contrast an explanation based on anticipations of quantitative easing is inconsistent because stock prices went one way on August 10 and another way on August 27.

In any case these interest rate and stock price data raise doubts about the narrative that long-term interest rates fell and stock prices rose in anticipation of QE2. As with all the other stimulus programs tried in recent years, it is important to get the narrative right, and more empirical work is welcome.

Hmm.. as Bernanke cannot comment much, we are only likely to hear from Taylor and others supporting Bernanke move.

Though, Bernanke adds in his op-ed that there is much uncertainty regarding QE and its effect:

While they have been used successfully in the United States and elsewhere, purchases of longer-term securities are a less familiar monetary policy tool than cutting short-term interest rates. That is one reason the FOMC has been cautious, balancing the costs and benefits before acting. We will review the purchase program regularly to ensure it is working as intended and to assess whether adjustments are needed as economic conditions change.

Although asset purchases are relatively unfamiliar as a tool of monetary policy, some concerns about this approach are overstated. Critics have, for example, worried that it will lead to excessive increases in the money supply and ultimately to significant increases in inflation.

Our earlier use of this policy approach had little effect on the amount of currency in circulation or on other broad measures of the money supply, such as bank deposits. Nor did it result in higher inflation. We have made all necessary preparations, and we are confident that we have the tools to unwind these policies at the appropriate time. The Fed is committed to both parts of its dual mandate and will take all measures necessary to keep inflation low and stable.

The Federal Reserve cannot solve all the economy’s problems on its own. That will take time and the combined efforts of many parties, including the central bank, Congress, the administration, regulators and the private sector. But the Federal Reserve has a particular obligation to help promote increased employment and sustain price stability. Steps taken this week should help us fulfill that obligation.

Fed remains the lone fighter in what I have argued is not just a liquidity trap, but policy trap as well. I also don’t understand these debates about inflation going up because of QE. Asset price inflation yes, but goods inflation is far away. Actually a higher goods inflation would be welcome given the slack in the economy. That is what the whole debate is about.

Overall, Bernanke is into such a difficult position. Say he did not pass a QE2 saying Fed does not much impact from the program. Markets would have tanked a bit and people would have criticised him for not doing as per expectations. And now he has, a different set of people have criticised him for doing too much and letting markets take over.

I really admire Bernanke for taking on so much public criticism. When Jim Rogers says Bernanke does not understand economics, it is like telling Rogers he does not understand commodities.

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