Bernanke, Trichet Expose Their Respective DNA: Caroline Baum
Two central banks look at the same underlying fundamentals, reach two different conclusions and take two different policy actions.
Last week the European Central Bank raised its benchmark interest rate to 1.25 percent from 1 percent, where it’s been for almost two years.
Also last week, the Federal Reserve moved ahead with its planned purchase of $600 billion of U.S. Treasuries, the second phase of its quantitative easing program. As for any increase in the federal funds rate, which has been at 0 percent to 0.25 percent for 28 months, it won’t happen at the earliest until March of next year, based on expectations imbedded in fed funds futures’ prices.
For the ECB’s Jean-Claude Trichet, the goal of the rate increase was to prevent “second-round effects in price and wage-setting behavior” from boosting inflation further. Euro- zone inflation rose 2.6 percent in March from a year earlier, above the ECB’s target of no more than 2 percent over the medium term. Trichet judged that the action was warranted to anchor inflation expectations.
Stateside, Fed chief Ben Bernanke looked at U.S. inflation of 2.1 percent and came to the opposite conclusion. He told an Atlanta Fed conference last week that any inflation from commodity prices would be “transitory” as long as inflation expectations remain “stable and well-anchored.”
Who’s right?
Two Roads Diverged
The two decisions (one to act, the other to defer action) reflect to some degree the bank’s different mandates. The ECB, like the German Bundesbank before it, is entrusted with maintaining price stability, which it defines as an inflation rate below, but close to, 2 percent over the medium term. Toward that end, it employs a “two-pillar” strategy of economic and monetary analysis.
Inflation is a monetary phenomenon, so money must be at the root of that evil.
Unemployment may be high in Europe -- 20.5 percent in Spain, for example -- and three of its member states needed financial bailouts, but that isn’t the ECB’s problem, or, more correctly, its job. It makes life much easier when a central bank has to answer to only one master.
The Fed has a dual mandate: stable prices and maximum employment. It has a vague definition of price stability bequeathed by that “Master of Garblements,” former Fed chief Alan Greenspan. (His definition: a level of inflation low enough so that it doesn’t affect business or consumer decision-making.) And it relies on a squishy concept like the output gap, an estimate of economic slack, as a policy guide.
Lab Experiment
So here we have two lab rats staring at the same global commodities boom -- the result largely of increased demand but also of supply constraints (weather) and disruptions (Japan’s earthquake, tsunami and nuclear disaster) -- and responding differently. Why?
I have long suspected the answer lies in nature and nurture.
Etched in the collective unconscious of European central bankers is the memory of hyperinflation in 1920s Germany. If it isn’t in their DNA, it’s drummed into them at an early age.
In the U.S. the seminal event, or key failure of central bank policy, was the deflation of the Great Depression. Economists Milton Friedman and Anna Schwartz put the primary blame squarely on the Fed, which allowed the money supply to contract by more than 25 percent between 1929 and 1933.
Promises, Promises
Who can forget Bernanke’s promise to the two of them at a 2002 conference to honor Friedman on his 90th birthday? “I would like to say to Milton and Anna: Regarding the Great Depression. You’re right, we did it. We’re very sorry. But thanks to you, we won’t do it again.”
It’s not a promise Bernanke will risk breaking. While the deflation threat has passed, Bernanke remembers the Fed’s second major failure in 1936-1937: raising reserve requirements.
Banks had built up their deposits at the Fed as a precaution against bank runs. The Fed viewed those deposits as potentially inflationary, so it increased the percentage of reserves that couldn’t be loaned out.
Bernanke is in no rush to pare the Fed’s balance sheet or raise interest rates unless inflation expectations break free from their moorings. Currently a market-based measure of five- year inflation expectations five years from now is 3 percent, above the Fed’s implicit target of 1.5 percent to 2 percent.
While Fed officials talk about avoiding inflation, their behavior suggests deflation is the greater fear. In the mid- 1990s, for example, Greenspan sniffed out an increase in productivity growth, which had slumped in the previous two decades. Technological innovation, absent the central bank, would result in falling prices. That’s what economists call “good deflation,” driven by productivity growth, not the “bad deflation” of the 1930s.
Walk the Talk
At the time, the Richmond Fed’s Al Broaddus and Marvin Goodfriend argued that the situation called for higher real interest rates. Greenspan saw things differently, and the result was the first of two asset bubbles.
He should have realized the benefits of good deflation. What better way to anchor inflation expectations than a bout of falling prices?
If it’s expectations that keep central bankers awake at night, the ECB may have bought more credibility with its 25 basis points than the Fed did with all its talk.
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