The topic of this conference--the formulation and conduct of monetary policy in a low-inflation environment--is timely indeed. From the late 1960s until a decade or so ago, bringing inflation under control was viewed as the greatest challenge facing central banks around the world. Through the application of improved policy frameworks, involving both greater transparency and increased independence from short-term political influences, as well as through continued focus and persistence, central banks have largely achieved that goal. In turn, the progress against inflation increased the stability and predictability of the economic environment and thus contributed significantly to improvements in economic performance, not least in many emerging market nations that in previous eras had suffered bouts of very high inflation. Moreover, success greatly enhanced the credibility of central banks' commitment to price stability, and that credibility further supported stability and confidence. Retaining that credibility is of utmost importance.
Although the attainment of price stability after a period of higher inflation was a landmark achievement, monetary policymaking in an era of low inflation has not proved to be entirely straightforward. In the 1980s and 1990s, few ever questioned the desired direction for inflation; lower was always better. During those years, the key questions related to tactics: How quickly should inflation be reduced? Should the central bank be proactive or "opportunistic" in reducing inflation? As average inflation levels declined, however, the issues became more complex. The statement of the Federal Open Market Committee (FOMC) following its May 2003 meeting was something of a watershed, in that it noted that, in the Committee's view, further disinflation would be "unwelcome." In other words, the risks to price stability had become two-sided: With inflation close to levels consistent with price stability, central banks, for the first time in many decades, had to take seriously the possibility that inflation can be too low as well as too high.
A second complication for policymaking created by low inflation arises from the fact that low inflation generally implies low nominal interest rates, which increase the potential relevance for policymaking of the zero lower bound on interest rates. Because the short-term policy interest rate cannot be reduced below zero, the Federal Reserve and central banks in other countries have employed nonstandard policies and approaches that do not rely on reductions in the short-term interest rate. We are still learning about the efficacy and appropriate management of these alternative tools.
The preceding paragraphs were the first three of Bernanke's speech on Friday and they have been on my mind for the last few days. Let me explain why.
First, here is a chart of the year over year percentage change in inflation:
There are two periods. The first is 1960-the early 1980s, which are characterized by higher and higher inflation. This ended after Paul Volcker's tenure at the Fed. From 1980 onward, inflation has been relatively subdued. It has increased before all the major recessions, but the highest year over year total we've seen is a little over 5% -- hardly a problem.
As Bernanke notes, low inflation implies low interest rates. Here is a chart of the 10 year CMT Treasury for the last 40+ years:
Notice that as inflation has come under more and more control, interest rates have come down.
Let's think about this from a policy perspective. The big problem with low inflation is low interest rates, which in turn can lead to speculative bubbles. As money gets cheaper and cheaper (as its cost drops) it becomes more and more likely that people will borrow money. In other words, a central cause of the financial bubbles we've been seeing over the last 20 years is low interest rates -- and the Feds continual lowering of rates to stimulate the economy. But this was caused by the Fed being successful in limiting inflationary forces in the economy.
I realize this is a chicken or the egg type of circular flow, but it's very important to understand exactly what has been going on for the last 30 years. Because inflation is less of an issue, the Fed has been able to lower short-term interest rates. This in turn has created several speculative bubbles.
In other words, it's distinctly possible the economy needs more inflation than we currently have.
