Bernanke vs. Baum

Fed Chairman Ben Bernanke argues that targeting core inflation is appropriate because, otherwise, the Fed would have to “force down wages and other prices quite dramatically to keep the overall price level from rising” in the face of rising energy prices. Bloomberg columnist Caroline Baum (hat tip: Mark Thoma) objects:

In order to offset the immediate effect of a rise in energy prices, the Fed wouldn't have to do anything. The price of something else would fall, all things equal, as consumers adapt to the constraints on their budgets (paying more for gas means less money for other goods).

I have (at least) four problems with Ms. Baum’s argument.

First, I have a basic philosophical problem with clauses like “the Fed wouldn't have to do anything.” What exactly is meant by not doing anything? I suppose they could hang “Gone Fishing” signs on the doors of all the Federal Reserve Banks and tell all the employees to go home and be with their families for a few months. No doubt this would succeed in getting prices down, but I don’t think it’s what Ms. Baum has in mind. It’s really quite arbitrary what course of Fed action is defined as being passive. Keep the monetary base constant? Keep the interest rate constant? Increase the monetary base at a 2% annual rate? At a 10% annual rate? Follow a Taylor rule? Ms. Baum’s whole argument is premised on the idea that there is some “default” course for the Fed. But who gets to define that default? No doubt she can define the default in a way that will produce, on average, the results she imagines, but someone else will define the default differently.

Second, let’s accept the default that she perhaps has in mind, maybe some ideal constant money growth rule, and let’s assume away all the uncertainties about velocity of money and potential output. Increases in the average price level are caused, according to the cliché, by “too much money chasing too few goods.” Ms. Baum assumes that “too much money” is the problem. In the case of energy, however, it is more likely “too few goods.” In other words, if the Fed were following a passive money supply rule, an adverse oil shock would cause the average price level to increase anyhow. If oil becomes scarcer but money remains equally plentiful, the value of money – in terms of some basket that includes oil and products made with oil – will go down.

Third, even if my first two objections didn’t apply, let’s just imagine that Bernanke is using imprecise language by casting the Fed’s behavior as active rather than passive. Let’s say it is not the Fed but the market that has to “force down wages and other prices quite dramatically to keep the overall price level from rising.” That’s still a bad thing, because most wages and prices don’t go down without a fight, and the fight usually takes the form of a recession. The Fed is willing – actively or passively, depending on your economic theory and your semantic preferences – to accept temporary increases in the headline inflation rate in order to avoid unnecessary recessions. That strikes me as not only good judgment, but also the clear duty of the Fed under its current mandate.

Finally, let me make a basic point about the nature of oil as a commodity: oil is storable. If the price of is expected to rise, there will be strong incentive (provided that storage costs and interest rates are not too high) to hold large inventories in anticipation of higher prices. In practice, we never observe huge inventories, because producers, facing expected price increases, choose to delay production, which causes prices to increase immediately. In any case, the nature of the oil market is such that, normally, the most knowledgeable people will never, on average, be expecting large price increases. Otherwise, those price increases would already have happened. If the Fed’s objective is to stabilize prices going forward, then the Fed is operating well within reason to assume that oil prices will not rise dramatically. It is taking the market’s judgment, effectively outsourcing the task of forecasting oil prices. Past increases in oil prices are irrelevant, and it is rational for the Fed to ignore them by using core inflation as its measure of past price growth.