Pretty disappointing, but with one silver lining.  We pretty much know where the “Bernanke put” is, he drew a line at roughly 1% core inflation.  That means no more “depression economics.”  Let’s get costs down and we can get a faster economic recovery:

1.  Payroll tax cuts (at the margin, employer only.)

2.  Replace unemployment extended benefits with large lump sum payments to the unemployed.

3.  Temporary (two year) minimum wage cuts to $6.50.

Of course this won’t happen, but it would promote faster growth if it did.  They are things Obama could try.  Now for the speech:

Maintaining price stability is also a central concern of policy. Recently, inflation has declined to a level that is slightly below that which FOMC participants view as most conducive to a healthy economy in the long run. With inflation expectations reasonably stable and the economy growing, inflation should remain near current readings for some time before rising slowly toward levels more consistent with the Committee’s objectives.

Translation:  The Fed defines price stability as about 2% inflation, and it’s running around 1% (core inflation.)  Bernanke thinks that’s a bit lower than desirable.  But then there is also this:

A rather different type of policy option, which has been proposed by a number of economists, would have the Committee increase its medium-term inflation goals above levels consistent with price stability. I see no support for this option on the FOMC. Conceivably, such a step might make sense in a situation in which a prolonged period of deflation had greatly weakened the confidence of the public in the ability of the central bank to achieve price stability, so that drastic measures were required to shift expectations. Also, in such a situation, higher inflation for a time, by compensating for the prior period of deflation, could help return the price level to what was expected by people who signed long-term contracts, such as debt contracts, before the deflation began.

However, such a strategy is inappropriate for the United States in current circumstances. Inflation expectations appear reasonably well-anchored, and both inflation expectations and actual inflation remain within a range consistent with price stability.

Aaaargh!!  So which is it?  Is inflation too low, or not?

I wish those prominent economists calling for 4% inflation had followed my advice.  Call for level targeting.  Draw a 2% trend line for core inflation from September 2008.  We are now 1.4% below that trend line.  Shoot for getting back to trend.  I know that doesn’t sound like much stimulus, but given the slack in the economy it would actually take pretty fast NGDP growth to get 3.4% core inflation over 12 months.  Or 2.7% over 24 months.  You’ll never convince the Fed to change its inflation target to 4%, and there is no need to try.

But Bernanke definitely does understand the logic of the argument I have been making in recent posts:

First, the FOMC will strongly resist deviations from price stability in the downward direction. Falling into deflation is not a significant risk for the United States at this time, but that is true in part because the public understands that the Federal Reserve will be vigilant and proactive in addressing significant further disinflation. It is worthwhile to note that, if deflation risks were to increase, the benefit-cost tradeoffs of some of our policy tools could become significantly more favorable.

Second, regardless of the risks of deflation, the FOMC will do all that it can to ensure continuation of the economic recovery. Consistent with our mandate, the Federal Reserve is committed to promoting growth in employment and reducing resource slack more generally. Because a further significant weakening in the economic outlook would likely be associated with further disinflation, in the current environment there is little or no potential conflict between the goals of supporting growth and employment and of maintaining price stability.  (italics added.)

Translation:  “Listen you inflation hawks, if things get even a tiny bit worse we will need more stimulus not just to boost growth, but to prevent further disinflation.”

I think we are already there, where more nominal growth is a win/win, and my hunch is that (to a lesser extent) Bernanke agrees.  After all, he basically said that in the first quotation I gave you, which I take to be his true feelings.  The hawks would never have said inflation is too low.  Bernanke is a patient man, but he is running out of patience.  Let’s hope the three new Board members push him hard this fall.

So if Bernanke wants to do more, why doesn’t he say so?  He explained why, if you read between the lines:

Central banks around the world have used a variety of methods to provide future guidance on rates. For example, in April 2009, the Bank of Canada committed to maintain a low policy rate until a specific time, namely, the end of the second quarter of 2010, conditional on the inflation outlook.4 Although this approach seemed to work well in Canada, committing to keep the policy rate fixed for a specific period carries the risk that market participants may not fully appreciate that any such commitment must ultimately be conditional on how the economy evolves (as the Bank of Canada was careful to state). An alternative communication strategy is for the central bank to explicitly tie its future actions to specific developments in the economy. For example, in March 2001, the Bank of Japan committed to maintaining its policy rate at zero until Japanese consumer prices stabilized or exhibited a year-on-year increase. A potential drawback of using the FOMC’s post-meeting statement to influence market expectations is that, at least without a more comprehensive framework in place, it may be difficult to convey the Committee’s policy intentions with sufficient precision and conditionality. The Committee will continue to actively review its communication strategy, with the goal of communicating its outlook and policy intentions as clearly as possible.

Translation:  We can’t communicate a clear objective because unlike in Canada and Japan, I can’t get those hawks to agree with my view of the appropriate “comprehensive framework.”  We will try to make our intentions as clear as possible, if we can ever agree on what they are.

[BTW, notice how in 2001 the BOJ promised to tighten policy as soon as inflation reached zero?  If you have deflation for years, and tighten the moment you hit zero (which was 2006) won’t you go right back into deflation?  The answer is yes.  So much for Paul Krugman’s theory that the BOJ is valiantly struggling to avoid deflation.]

What if more stimulus is needed, does the Fed have more ammo?

The issue at this stage is not whether we have the tools to help support economic activity and guard against disinflation. We do. As I will discuss next, the issue is instead whether, at any given juncture, the benefits of each tool, in terms of additional stimulus, outweigh the associated costs or risks of using the tool.

So Congress and the President are desperately looking for ways to boost demand, w/o ballooning the deficit.  The Fed has such tools, but sees no need to use them.  And what is the most likely tool?

A first option for providing additional monetary accommodation, if necessary, is to expand the Federal Reserve’s holdings of longer-term securities. As I noted earlier, the evidence suggests that the Fed’s earlier program of purchases was effective in bringing down term premiums and lowering the costs of borrowing in a number of private credit markets. I regard the program (which was significantly expanded in March 2009) as having made an important contribution to the economic stabilization and recovery that began in the spring of 2009. Likewise, the FOMC’s recent decision to stabilize the Federal Reserve’s securities holdings should promote financial conditions supportive of recovery.

I believe that additional purchases of longer-term securities, should the FOMC choose to undertake them, would be effective in further easing financial conditions. However, the expected benefits of additional stimulus from further expanding the Fed’s balance sheet would have to be weighed against potential risks and costs. One risk of further balance sheet expansion arises from the fact that, lacking much experience with this option, we do not have very precise knowledge of the quantitative effect of changes in our holdings on financial conditions. In particular, the impact of securities purchases may depend to some extent on the state of financial markets and the economy; for example, such purchases seem likely to have their largest effects during periods of economic and financial stress, when markets are less liquid and term premiums are unusually high. The possibility that securities purchases would be most effective at times when they are most needed can be viewed as a positive feature of this tool. However, uncertainty about the quantitative effect of securities purchases increases the difficulty of calibrating and communicating policy responses.

Another concern associated with additional securities purchases is that substantial further expansions of the balance sheet could reduce public confidence in the Fed’s ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations. (Of course, if inflation expectations were too low, or even negative, an increase in inflation expectations could become a benefit.) To mitigate this concern, the Federal Reserve has expended considerable effort in developing a suite of tools to ensure that the exit from highly accommodative policies can be smoothly accomplished when appropriate, and FOMC participants have spoken publicly about these tools on numerous occasions. Indeed, by providing maximum clarity to the public about the methods by which the FOMC will exit its highly accommodative policy stance–and thereby helping to anchor inflation expectations–the Committee increases its own flexibility to use securities purchases to provide additional accommodation, should conditions warrant.

Translation:  It worked last time (March 2009), there are a few minor problems, but we have addressed those problems.  He mentions other ideas like better communication and lower IOR, but you get the impression that he is much less enthusiastic about those ideas.  My guess is that he would only do a comprehensive stimulus with all three tools if things got really bad.  Actually things are really bad; I mean  if things got really, really bad.  If 3rd quarter NGDP growth comes in around 3% or lower, look for more QE in the fall (when the three new members are seated.)  BTW, I am less confident than Bernanke that QE worked last time.  But it is definitely better than nothing.

CNBC discusses the views of Dallas Fed President Fisher:

Signs are rife that the U.S. economic recovery is slowing, with retail and housing sales down, manufacturing slowing, and unemployment at a stubbornly high 9.5 percent. Some Fed officials, including Fed Chairman Ben Bernanke, have recently raised the possibility that the Fed may need to ease monetary policy further if the economy worsens.

Fisher said such a move would be ineffective, and could even make matters worse.

Businesses are distressed and dispirited by uncertainty over upcoming rule changes and are unable to conduct long-term planning, he said.

“They are calling time-outs and heading to the sidelines while they wait for the referees to settle on the rules of the game,” Fisher said. “If this is so, no amount of further monetary policy accommodation can offset the retarding effect of heightened uncertainty over the fiscal and regulatory direction of the country.”

I don’t get this at all.  There was lots of governmental activism during the Lyndon Johnson years, and yet rapid NGDP growth led to rapid RGDP growth.  During FDR’s first term there was far more activism and far more uncertainty than right now, but fast NGDP growth led to fast RGDP growth.  I’m no fan of Obama’s policies; I think they have modestly increased the structural rate of unemployment.  But monetary stimulus remains the key to recovery.  It will also eventually lead to fewer policies that reduce aggregate supply, such as extended UI benefits.

Fisher sought to assure his audience that the Fed will not allow itself to be pushed into printing money to resolve the deficit and signaled he would would oppose any further easing on that basis.

Of course he has things exactly backward.  Many of the spending programs that he doesn’t like were undertaken precisely because monetary policy reduced NGDP nearly 8% below trend between mid-2008 and mid-2009.  And the current recovery is anemic, with NGDP growing at less than 40% of the rate it grew during the 1983-84 recovery.

Calling price stability the Fed’s “ultimate goal,” he said the U.S. central bank will not tolerate either inflation or deflation.

“The Federal Reserve is absolutely committed to its goal of achieving price stability,” he said. “This entails keeping inflation extremely low and stable.”

I’ve already said enough about “opportunistic disinflation.”

Paul Krugman recently contested my argument that Japan is not stuck in any sort of deflationary trap.  Ryan Avent already showed why Krugman doesn’t have much of an argument:

And…I’m genuinely mystified. The only thing I can think of that would square this circle is if Mr Krugman and I are using different definitions of the word “prefer”. As best I can tell, he has conclusively shown that Mr Sumner is right, and Japan hasn’t been in a deflationary trap. It just needs to fire all of its central bankers.

I’m not surprised that Krugman wants to claim the BOJ is stuck in a deflationary trap; he published the best model we have to explain why that might happen.  But I’m afraid it didn’t happen, and although Avent’s post is pretty definitive, even he didn’t address all of the problems with Krugman’s argument.

Let’s start with his response to my admission that my view is the minority view:

He guesses right: that’s not at all the view of those who have been following Japanese monetary policy since the 1990s, and have even talked to BOJ people now and then.

So Bank of Japan officials are not publicly admitting to favoring mild deflation.  Is that really surprising?  And regarding “those who have been following Japanese monetary policy since the 1990s” (does that include me?), I was under the impression that many of them were highly critical of Japanese monetary policy for being too contractionary.  That sort of criticism of the BOJ is hardly consistent with the view that the Japanese are “stuck” in some sort of deflationary trap.

As far as I can tell, the Fed has an implicit target of roughly 2%, maybe a bit less.  The ECB is about the same, perhaps a bit lower.  The BOJ has target of stable prices, which means zero inflation.  I don’t know what inflation index they use, but their CPI has been amazingly stable since February 2002 (roughly when the QE started.)  The CPI was 100.1 on February 2002, and is now 99.7.  That’s a grand total of 0.4% deflation over a period of 8 years!  Price stability just doesn’t get any better than that.  Other that a few months in 2008, when oil prices soared, the Japanese CPI never moved more than 1% up or down from the February 2002 figure.  (BTW, the Bullard study that I was commenting on looked at 2002-10 data.)   If you don’t like my February 2002 starting point, the Japanese CPI has fallen by a grand total of 0.5% since June 1993, a period of 17 years.  Not per year—total.  So if the CPI is their target, then the Japanese just might be the most skilled central bank in all of world history.  Who else has produced such absolute price stability!

Now I will admit that the core inflation rate shows a bit more deflation, but it’s still pretty close to price stability.  (Eyeballing the graph in the Bullard paper, it looks like about 0.3%/year deflation since 2002.)  So the BOJ really isn’t very far off target, even if you use the core rate.  But let’s take the worst case, and assume the BOJ prefers stable prices to very slight deflation.  I still think Krugman is wrong.  And the reason is that the BOJ abhors positive inflation like a vampire fears sunlight.  So when there is any sign of inflation, the BOJ immediately does something contractionary.  They always err on the side of mild deflation, even if their first best choice is precisely zero inflation.

Krugman points to the large increase in the monetary base during the early 2000s, but skims over the big drop in 2006, indeed doesn’t even consider it to be that dramatic.  I’d consider a drop of over 20% from peak to trough to be pretty dramatic, as far as I know it is larger than any monetary base drop experienced by the US in the past 100 years, including the Great Deflation of 1920-21.  But let’s say Krugman’s right and that it’s no big deal; that still doesn’t explain why it occurred.  The explanation seems obvious to me; the BOJ was terrified that after years of very mild core deflation, they might have 1% inflation.  So they tightened monetary policy, just as you’d expect a central bank to do if it wasn’t “trapped.”

Krugman also argues that depreciating one’s currency is not as easy as it looks, and points to the Swiss case.  First of all, I think we both agree that there is no technical barrier to depreciating a currency; the central bank can offer to sell unlimited amounts of its currency at a lower value than the current exchange rate.  The risk Krugman refers to is that they might have to buy up a lot of assets, and then later sell them off to prevent an outbreak of inflation (with a risk of capital losses.)  That’s a fair point, but it probably applies more to a small country whose currency is a popular safe haven, than to Japan.  It’s hard for me to believe that the sort of monetary base increase required to depreciate the yen would expose the BOJ to unacceptable risk of capital loss.  And if it did, it begs another question; if they don’t want a big and volatile monetary base, what the heck are they doing setting a zero inflation target?  A two or three percent inflation target will result in a much lower monetary base to GDP ratio, and probably a more stable one as well.

So here is where we are:

1.  The Japanese are supposedly stuck in a deflationary trap, even though their CPI has been amazingly close to their zero long run inflation target.

2.  Even the core CPI shows only exceedingly mild deflation

3.  Every time the rate of inflation threatened to break above zero, the BOJ tightens monetary policy.

4.  It’s known that temporary currency injections are ineffective, but the BOJ nonetheless sharply reduced the base in 2006 only a few years after doing QE.

5.  The BOJ refuses to set a 2% inflation target, like normal central banks.

How in the world is all that not consistent with a central bank that officially targets zero inflation, but would prefer a bit of deflation to a bit of inflation?  And since absolutely perfect price stability is a practical impossibility, didn’t the BOJ get the mild deflation that they clearly prefer to mild inflation?  So what precisely is the problem?  Where is the policy failure?  I just don’t see it.

Sometimes I think you need to stand back and look at how policymakers act, not what they say.  For example, every time President Carter or President Clinton put out feelers about normalizing relations with Cuba, Castro would commit some outrage, to undercut the initiative.  At some point don’t you have to ask yourself whether Castro really wants 100,000s of rich Cuban-American tourists flaunting their wealth, buying up hotels in Havana.  How long would communism last if Castro couldn’t use the trade embargo as an excuse?   (Which is precisely why an anti-communist like me has always been opposed to the embargo.)

My hunch is that if Krugman was sitting around a poker table with his former colleagues Svensson, Bernanke and Woodford, having a few beers, they wouldn’t be talking about how sorry they felt for the poor BOJ officials, unable to escape their quicksand-like deflationary trap.  The only debate would be over whether they were incompetent buffoons or evil reactionaries.  (I believe they are well-intentioned reactionaries.)

I’ll grant Krugman one very important point.  He was one of the first to point to the conservative nature of modern central bankers, and how their strong desire to maintain a reputation as inflation fighters threatens to drive the world into deflation (or at least disinflation.)  It looks like Krugman might have been right.  But I’m not willing to grant them a sort of “central bankers will be central bankers” excuse.  The world shouldn’t have to spend trillions on fiscal stimulus just because central bankers have made a fetish of stable prices.

Believe me, if you put 12 Paul Krugmans on the BOJ policymaking board, you’d get inflation.

John Makin recently warned that the US economy faced a risk of deflation.  Paul Krugman suggested that it might already be here.  I believe that outright deflation may have actually come and gone.  Nonetheless, I agree that sub-normal inflation will continue to delay the recovery, and support their calls for easier money.

A year ago I did a post discussing flaws in the way the US government computes price indices.  Official government statistics showed that housing prices were rising, even relative to other goods, between mid-2008 and mid-2009.   I hope I don’t need to explain how crazy that is—we were in the midst of the greatest housing price crash in American history (at least since record-keeping began.)   Because housing makes up 39% of the core inflation rate, it is quite possible that we actually experienced deflation in late 2008 and early 2009, even in the core rate.

The basic problem is that housing “prices” are based on imputed rents from out-of-date rental contracts signed while prices were still much higher, and which also ignore the frequent offers of one or two months rent-free on new contracts signed during the recession.  This is only slightly better than estimating housing costs on the basis of current monthly payments on 30 year mortgages taken out in 1981.

On implication of the flawed data is that the overall inflation rate was probably much lower than the official data showed during 2008-09.  Another implication is that at a later date these same sources will probably understate the actual rate of inflation.  I believe that has already begun to occur, and may explain part of the discrepancy between the two graphs in Krugman’s post.  As a result I think the second graph is more accurate—we now have low but slightly positive inflation.  Still, as Krugman argued in today’s column, we need much higher inflation if we are to have a robust recovery.

PS.  I was asked if I had ghostwritten Krugman’s most recent column.  All I am able to tell you is that thus far Paul Krugman has not authorized me to confirm or deny ghostwriting any of his columns.   Should I receive such authorization, I will let you know.

Seriously, he has made these points on some other occasions.  But I think he is certainly becoming more forceful on the subject of monetary policy, and other bloggers apparently share that perception.  In late 2008 I began this crusade amidst a widespread perception that the Fed had run out of ammunition.  I argued that it was fiscal policy that was out of bullets, that the $780 billion stimulus was probably all we would get.  I argued that monetary policy was our only hope.  I think it is fair to say that these views are now considerably more widespread than in late 2008 and early 2009.  I can’t say whether this blog has played any role in changing the intellectual climate on these issues, but at least I feel like I haven’t been wasting my time.  As I said in a recent post, “truth” is the view that gets accepted by my peers in the long run.  So my ideas are “truer” than 20 months ago.

PPS:  Makin and Krugman’s warning can also be interpreted as referring to the risk of deflationary expectations setting in.  That would be different from the transitory deflation of 2008-09.