Testifying before Congress today, Ben Bernanke explained that inflation won’t spiral out of control even if the economy recovers because the Federal Reserve can put the brakes on at any time:
No it will not. We know how to reverse what we did, we know how to take the money out of the system, we know how to raise interest rates. So it will be a similar pattern to what we have seen in previous episodes where the Fed cut rates, provided support for the recovery and when the economy reached a point of take off, where it could support itself on its own, the Fed pulled back, took away the punch bowl. And we can do that and we will do that when the time comes.
But in response to a different question, Bernanke said the Federal Reserve can’t shift to a higher inflation target without inflation spiraling out of control:
I recognize that some people would advocate that we set an inflation target at, say, 4 percent and maintain that for a number of years. I don’t think first that we could do that without losing control of the inflation process. Secondly, I’m very skeptical that it would increase confidence among businesses and households that increase economic activity. I think it would create a lot of problems in financial markets as well. And so I don’t think that’s a strategy that has a lot of support on the Federal Open Market Committee.
This completely contradicts Bernanke’s other much more sensible statement. And while it’s not my favorite policy proposal, it would certainly be better than sticking with the status quo. Unfortunately none of the members of Congress seemed to be sufficiently well-informed to ask Bernanke any follow-ups. For starters, Why would this possibly cause them to lose control? And does Bernanke think this holds generally: No central bank anywhere can ever adjust its inflation target upward without unleashing an uncontrollable price spiral, so Japan must stick forever with deflationary regime? I don’t think Bernanke thinks that.
The confidence argument, meanwhile, is nonsense that ought to be beneath the dignity of a distinguished scholar. Suppose you’re a household considering whether or not to take money out of your bank account and go buy a new refrigerator. Now you get new information indicating that future price increases will come more rapidly than expected. Are you now more likely or less likely to go out and buy the fridge? More likely. And suppose you’re a bank considering whether or not to lend some money for new house construction and you learn that future rent increases will come more rapidly than expected. Are you now more likely or less likely to fund the investment? More likely. And by the same token if you build refrigerators you’re more likely to invest in increased capacity.
