By Richard Alford, a former economist at the New York Fed. Since then, he has worked in the financial industry as a trading floor economist and strategist on both the sell side and the buy side.
A week ago, in Atlanta, Bernanke responded to his critics, including John Taylor of Taylor Rule fame (the Taylor Rule is a benchmark widely used by central banks in setting their “policy” interest rates). Bernanke asserted that monetary/interest policy has been appropriate-and was not” too low for too long” from 2001-2006. Taylor responded in a WSJ Op-Ed piece on January 11th reasserting his position that interest rates were “too low for too long”. A very public debate has been joined. Taylor’s view is based on his chosen variant of the Taylor Rule, while Bernanke cites his own chosen variant of the Taylor rule.
This post establishes that interest rates were “too low for too long” (from 1996-2006) while dispensing with the Taylor Rule and its sensitivity to choices of inputs and assumptions. It does so in a framework that employs definitions and measures favored by Bernanke. The frame work of the analysis is then used to answer other questions about economic policy in the past and going forward.
The Deflationary Threat?
Price stability/inflation targeting has been center stage of interest rate policy since Japan began its lost decades. Fear of deflation dominated the thinking of the Fed. This was especially evident in the response to the recession of 2001. The decidedly expansionary monetary policy adopted at the time was justified in terms of preventing a deflationary episode like Japan’s. In a February 2002 speech titled “Deflation: Making Sure ‘It’ Doesn’t Happen Here.” Bernanke defined deflation as:
“Deflation is a general decline in prices, with emphasis on the word “general”.
Bernanke was drawing a distinction between changes in relative prices of some goods on the one hand and deflation – pervasive declines in prices – on the other. Later in the speech, Bernanke re-emphasized the point: “Deflation per se occurs only when price declines are so widespread that broad-based indexes of prices register ongoing declines.” However, Bernanke and the Fed allow for exceptions. For example, food and energy inflation/deflation have been ignored even when changes in food and energy prices registered on broad-based indexes.
In the speech, Bernanke also specified the cause of deflation: “Deflation is in almost all cases a side effect of a collapse of aggregate demand –a drop in spending so severe that producers must cut prices…to find buyers.” In a footnote, Bernanke added:” I don’t know of any unambiguous example of a supply-side deflation, although China in recent years is a possible case.”
Bernanke therefore defines a deflation as a generalized, broad-based, widespread decline in prices brought on by a severe drop in spending. The 425 bps of rate cuts in the Fed funds target during 2001 was presented as necessary to prevent a demand-lead deflationary spiral.
However, a simple decomposition of Bernanke’s favorite inflation measure, the PCE, for the bubble years 1996-2006 indicates that price declines were not broad-based, widespread, or “general”, but localized even as they introduced disinflation to the broad-based price indexes. Furthermore, there is evidence that demand by US-based economic agents did not drop below the level implied by full employment.
Chart (I) is of the PCE (and its components) price deflator(s). It clearly indicates that deflationary pressure was far from broad-based or generalized. The deflationary pressure was confined to the consumer durable goods component of PCE. The durable goods component had a weight between 12 to 13% during the period 2001-2006.
