By Daniel Hanson
While being questioned in his Semi-Annual Report to Congress, Federal Reserve Chairman Ben Bernanke was criticized as dovish for his expansion of the Fed’s balance sheet. In response, Bernanke retorted, “You called me a dove...My inflation record is the best of any of the governors in the post-war period.”
The Bernanke Fed has interpreted its mandate for price stability as a call for a 2 percent inflation target. Fearing deflation, the tolerable lower bound for inflation at the Bernanke Fed has been about 0.6 percent, as the Fed initiated a $600 billion program in 2010 to combat deflation after the core consumer price index dropped to this low. In the name of spurring employment growth, the Bernanke Fed is willing to tolerate inflation as high as 2.5 percent, a position articulated in the FOMC’s December 2012 policy statement.
By and large, Bernanke has been successful in staying within these parameters. Headline inflation has averaged 2.3 percent since Bernanke took over, the second lowest average of any of the post-war Fed chairmen. But the Bernanke Fed is not as successful as its chairman thinks in correcting the inflation errors of the past.
Toward Zero Percent Inflation
Price stability has not always implied 2 percent annual inflation to the Fed’s board. In the 1950s and early 1960s, the goal of the Fed was literally price stability – zero percent inflation. By this measure, the most successful Fed chairman is William McChesney Martin. From 1951 to 1970, Martin kept inflation around 2.2 percent, with periods of slightly higher or slightly lower inflation throughout. Martin inherited Korean War inflation near 10 percent, and he pursued disinflation until deflation took hold of the economy. Notably, real GDP growth during the period of Martin’s deflation averaged 2.8 percent. This number, in line with historical trends in US expansion, questions the conventional wisdom about the problems associated with deflation.
The post-Martin era from the late 1960s to the mid-1980s came to be known as the “Great Inflation” because the Fed failed to keep inflation in check. Fed Chairmen Arthur F. Burns and G. William Miller presided over average annual inflation rates of 6.5 percent and 9.0 percent respectively. This period of high inflation was a remarkable failure of monetary policy that resulted in the bankruptcy of the thrift industry, heavy taxation of the US capital stock, arbitrary redistribution of wealth, and the destruction of the Bretton Woods system of fixed exchange rates.
Throughout the 1970s, Fed minutes show debates about interest rates over the coming month or two, with virtually no discussion about the longer run implications of their decisions. The most striking statement comes in the February 1972 minutes, where one FOMC member says, “It had not been demonstrated that total or nonborrowed reserves had any strong or direct effects on the ultimate goals of the economy.” As Federal Reserve historian Allan Meltzer has pointed out, this statement shows the Fed saw no clear link between money and prices or economic activity. This is a strange position for a central banker to hold, and one of the principal reasons the Fed was unable to contain inflation during this time.