Bernanke and the Pringles Problem

by Will Wilkinson on December 17, 2009

In response to this question:

Why haven’t you adopted a 3% per year inflation target?

Fed chair and Man of the Year Ben Bernanke said this:

The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations. In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward. The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored. [Emphasis added]

Now, I find monetary policy pretty confusing, which is to say that I find incompatible arguments persuasive. So I’m more or less agnostic about the policy the Fed ought to be pursuing. However, that the Fed ought to aim at something like a 3% inflation target is one of the arguments I find fairly persuasive. And Bernanke finds it fairly persuasive, too–at least “in theory.” So what’s wrong with the theory?!

I guess we could call it the “Pringles Problem”: Once you pop, you can’t stop! Bernanke seems to think that if the Fed tries to increase long-term inflation expectations once, a fair portion of the public will suspect that the Fed won’t be able stop, will act on the expectation of runaway inflation, and everything will go to shit. Or something like that. Or, in Bernanke’s words, “such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward.”

OK. But I believe that the Fed can eat just one. Bernanke believes the Fed can eat just one. (NB: The “Pringles Problem” is extensionally equivalent to the “Lay’s Problem.”) But some significant part of the “the public” does not. How exactly does one measure the public’s position on the Pringles/Lay’s Problem? How exactly does one assess the public’s “confidence” in the Fed’s willingness to resist upwards shifts in inflation, such that one could assess the risk that a one-time bump in the inflation target will dangerously undermine this confidence? Is there survey evidence about this? Anything? If the Fed can’t credibly signal a commitment to a theoretically sound monetary policy, why not? Is it that Ron Paul will start doing handsprings and all the hucksters hawking gold on Glenn Beck will go bananas if the Fed even flinches? (Wouldn’t it be interesting if goldbug catastrophism helps prevent the very inflationary eschaton it banks upon?) Or what?

Anyway, my educated hunch is that there is no sound technocratic science here, just the educated hunches of cautious technocrats. May Bernanke’s gut be true.

[Update: Here are Scott Sumner's thoughts on Bernanke's answer. Scott does not think Bernanke's gut is true.]

  • dlr
    ZERO INFLATION. A "stable currency" is one where there is ZERO INFLATION.

    Which in my opinion is exactly what the inflation target should be.
  • simonkinahan
    Bernanke can't grasp the concept because the concept doesn't mean anything. "Stable currency" in terms of what?
  • Brian H
    If Bernanke would promote stable currency, all would be well. But he can't choke out the words, much less grasp the concept.
  • Jeff, the Bank of England and many other central banks have explicit inflation targets.
  • Jeff
    Any kind of announced target by the Fed would violate the first law of bureaucracy, which is: "Above all, avoid accountability." When has any bureaucrat ever taken responsibility for anything?
  • The Pringle problem is beside the point. Changing the inflation target won't help unemployment. If expectations are anchored, the change in the target will be immediately reflected in expectations, having no effect on unemployment. If expectations become unanchored, there will be expectations of much higher inflation and in welfare terms we'll be in much worse shape whether or not unemployment decreases.
  • Klug
    How is Julian Sanchez any different from Matthew Yglesias?
  • adstein
    "The public" = the bond market. At least as I understand it.
  • I think this proves that inflation targets are flawed. The Fed doesn't really commit to much of anything, but there is reason to believe it is aiming for the core CPI to rise 2% of the the next year from wherever it happens to be now.

    If it instead targeted a growth path for the CPI, then if the CPI was below that path, having it rise extra fast to get it back up to that path should not generate expectations permanently higher inflation.

    Unfortunately, a target for a growth path of the price level sometimes requires the Fed to engineer a deflation of prices.

    A growth path for nominal expenditure--something like total final sales--would be much better.

    Nominal expenditure is still about 1% below its last peak and way below its past growth path, or even a growth path consistent with zero average inflation in the long run.

    If the Fed targeted a growth path for nominal expenditure, it is hard to see how inflation expectations could be unhinged. There is no way that persistent high inflation is consistent with slow growth in nominal expenditures.

    But the Fed worries that if it returns nominal expenditure to a reasonable growth path, then inflation will rise. They think people will project these inflation rates into the future.

    They need to change their approach
  • pithlord
    So he's running around yelling "Fire! Fire!" in Noah's Flood, so the drowning victims of Yahweh's wrath don't think he's soft on Ragnarok. Or something. What a silly, dangerous man.
  • Noah Yetter
    Puzzling. My current inflation expectation is 4% per year, so it's hard to see how setting a target at 3% would be an increase. At any rate, the adoption of a trillion dollar Quantitative Easing policy has shattered any credibility the fed may have had in terms of keeping inflation down. Once the economy gets itself back together we will see inflation get out of control in a hurry.
  • simonkinahan
    Bu you're way on the outside of the curve in believing that. If the world in general believed inflation was about to hit 4%, medium term rates would be AT MINIMUM 4%. As it is you'd be very lucky to find any risk-free bond yielding 4% right now. So Bernanke is right to be worried about expectations, even if your expectations turn out to be right, because if everyone else agreed with you, exactly what he's worried about would happen - rates would soar, and we'd be back in recession again.
  • Simonkinhan:

    The reason interest rates would soar if people expect higher inflation does not increase inflation. If people sell bonds and hold money, then the result is higher bond yields, an excess demand for money, and reduced current expenditure.

    If, on the other hand, they sell bonds and buy stocks (expected that nominal profits will rise with inflation,) or anything else, then then the higher interest rates do not adversely impact nominal expenditure in the present.

    Because the Fed describes its policies in terms of setting interest rates, there is a tendency to identify high interest rates with an excess demand for money. An excess demand for money does restrict expenditures (other things being equal.) And so, if you read "high interest rates" and interpret that to mean, the Fed engineers an excess demand for money, then you are sometimes right. But there are other things that can lead to high interest rates that are associated with more rapid growth in nominal expenditure. Sure, the higher interest rates do dampen expenditure, other things being equal. But this may be a dampening of an otherwise larger increase.

    Higher expected inflation tends to expand current nominal expenditures and the higher nominal interest rates only partially dampen that effect.
  • simonkinahan
    Fair point - high nominal bonds yield don't in and of themselves cause a recession. They only cause a recession if they're high relative to returns from other investments, so if the bond market's expectation of inflation is consistent with everyone else's and consistent with actual inflation, then there is no problem.

    But inflation expectations can lead actual inflation by an arbitrary amount of time, and if the bond markets were expecting 4% inflation in the coming year, and where WRONG that would indeed be contractionary, right?
  • oops..

    the reason interest rates soar if people expect inflation does not cause recession.
  • Brian H
    It's still not a sentence, and still doesn't make sense.
  • jsalvatier
    I am somewhat mystified by this. My understanding (which comes from Sumner, so maybe not an unbiased source) is that when Volcker decided to deal with inflation, he was able to do so credibly and quickly, despite a long history of inflation. That points strongly against Bernanke's hypothesis.
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