Will Bernanke Follow a Price-Rule Approach?

Tom Nugent joins Victor Canto in praising the appointment of Ben Bernanke to head the Federal Reserve:

Bernanke, like Greenspan and Volcker, will take a price-rule approach … Since 1982, some supply-siders have believed that the Fed shifted from a quantity rule for monetary policy to a price rule. In other words, the Fed gave up trying to control the supply of money, an approach recommended by Milton Friedman, and shifted to the use of one or more measures of inflation to guide the management of the fed funds rate to control inflation. For the period between 1982 and the present, a lot can be said about the approach of Fed chairmen Paul Volcker and Greenspan to managing the economy and inflation through the implementation of a price rule. A careful analysis of the relationship between the price rule, inflation, interest rates, and the stock market reveals that a price rule for monetary policy has made a lot more sense than a quantity rule for money … By adopting a price rule for monetary policy (which I consider on par with inflation targeting), the Fed, by definition, must give up attempting to control the quantity of money.

I suspect this form of praise hurts more than all the goofy criticism from the National Review. Brad DeLong, however, observes:

October of 1979 saw not an abandonment of the Federal Reserve’s monetarist targeting of monetary aggregates, but a reinforcement of them: a downweighting of indicators of market prices – interest rates – and an upweighting of indicators of liquidity quantities – the money stock measures. Canto has it exactly backward.

David Altig examines the historical record and counters Nugent’s claim that targeting inflation and targeting the price-level are the same thing:

The picture is pretty clear. If you believe that the FOMC has had an implicit inflation target of about 2%, the data since about 1992 would give you no argument. You have a little more trouble going back to the Volcker/early-Greenspan years … Which brings us to the key distinction between an inflation target and a price-level target. A central bank operating under an inflation target will let bygones be bygones: If inflation comes in above target is in any particular year, no conscious effort is made to undo the the effects on the level of prices by subsequently engineering inflation below the target … The actual average rate of PCE inflation over the period since 1992 has been just a tad over 2%. As a simple matter of arithmetic, a price-level target that allows the price level to grow at 2% will look almost exactly like a successfully maintained average-inflation target of 2%.

OK, the inflation rate has averaged 2% since 1992 – but that does not mean the Federal Reserve has adopted a price-level target. But suppose that did. Just imagine how much extra output variance we would get. While most economists would argue output variance is bad, the Bush cheerleaders and free-lunch supply-side crowd seems to love variance as it gives them the opportunity to cherry-pick data – as in that claim that the economy in late 20003 was the best we have had in twenty years.

A reader of Brad’s blog points us to some spin from Art Laffer:

In October 1982, on this page, I described Mr. Volcker’s version of a price rule for monetary policy. Essentially, the Fed targeted spot commodity prices by altering the rate of growth of the monetary base. And it still does today. This modified version of Milton Friedman’s monetary rule worked like a dream.”

Now I get it! By “it”, I mean Canto’s obsession with a commodity price-rule, which the rest of the nitwits at the National Review feel compelled to follow. Canto’s career has been trying to yield some credibility to Laffer’s nonsense. Laffer is a gold bug so Canto must be a gold bug.

Laffer claims today that Volker’s policy worked like a dream. He and his fellow supply-siders back in 1983 were singing a different tune at a conference on Reaganomics where the economists fell into three basic camps. One camp of conservative economists (let’s call them the new classical camp) were singing the praises of Volcker’s tight monetary policy, while a second camp (let’s call them the Keynesian camp) were cursing the same monetary policy on the grounds that it caused a deep recession. Laffer and his camp were singing the praises of how the Reagan fiscal stimulus would lead to incredible output growth. When the other two camps said “huh” – the Laffer camp joined with the Keynesian camp condemning Federal Reserve policy. But then Laffer took the podium and said there was little difference between the Keynesian view of fiscal policy and his view. At that point, the new classical and Keynesian camps just shook their heads at Laffer’s lack of integrity.

Over the years, I have grown a little softer on the Volcker FED understanding that his second dip of monetary contraction was a reaction (make that an overreaction) to Reagan’s fiscal irresponsibility. And while the floating exchange rate policy tended to soften the amount of investment crowding-out by having a second transmission channel in terms of net export crowding-out, the same exchange rate regime made the contractionary monetary policy even more potent.

Alas – Bernanke faces a similar problem with continued fiscal irresponsibility and a huge current account deficit. Do the National Review gold bugs really want us to adopt a Chinese style policy of making sure the dollar gets pegged to something that is undervalued given the state of fiscal policy? Is that their only cure for the current account deficit – since this “supply-side” crowd is incapable of endorsing fiscal responsibility?

But as think back to the difficult situation the Volcker FED was in at this time, I recall an excellent memo from two staff economists at Reagan’s Council of Economic Advisors. To be fair, Donald Luskin just reminded me that he neither understood what was on the first page of this memo nor realized that there were more pages.