Montag, Oktober 31, 2005

Bernanke and Targets...

Jeffrey Garten in today's FT gave me the impetus to write this. He correctly points out that Bernanke will have not merely the usual challenges in filling Greenspan's shoes - a tough enough challenge as is - but that he's gonna be faced with unknown challenges that will really put pressure on him to perform, but without the decades of experience in financial markets that Greenspan has. And that this is the real challenge for whoever is the Fed chairman.

We've had an enormously effective Chairman of the Fed over the last 18 years. Why has he been so successful?

Two reasons: first, Greenspan understood how the markets work, which is 75% psychology and 25% fundamentals. Second, he clearly states his policies in extremely careful wording to let the markets know what his concerns are, but has never stated any explicit goal.

Why has this been successdul? I think it's mostly the latter reason: never stating an explicit goal. He's never said "inflation should be at n%", he's never said "M2 should grow by n%". He's been criticized for this: lots and lots of people have been severely frustrated because they can't second-guess him. And they haven't been able to second-guess him because Greenspan is deliberately vague about his explicit goals.

Greenspan has been so successful because he doesn't tell everyone what he is doing: he leaves his options open. He's like the CEO of a company that refuses to tell analysts that growth for a company should be 10% for the next year. Telling analysts that you're going to have 10% growth means that you are setting yourself up for a fall when growth comes in at 9.2%: your stock will plummet because it hasn't met analysts' expectations.

And now we are getting a whiz kid who is more than happy to tell people what his goals will be: he will start setting inflation targets.

While this will make plenty of pundits happy, giving them something to write about. But it also means that the Fed will be held accountable for its explicit inflation targets, regardless of the reasons for making them and missing them. And he will miss them.

This is why I'm increasingly mistrustful of explicit targets. The ECB has had them and as a result has been subservient to them, forcing it to take actions that have led to poor economic growth in Europe in order to meet its targets.

And that's the cart driving the horse.

Bernanke will face huge challenges. He's a gifited academic and knows the Fed, having been a member of the board.

But why give up one of the most useful tools in managing the world economy? By being deliberately vague, Greenspan left himself all the tools of his trade open to make the adjustments necessary, but kept the actual process to himself.

This is a good thing: by making the process transparent, you open yourself up to massive punditry, very little of it competent, and you then are captive to the psychology of the market, rather than the other way around. It's a question of priorities: did you make analysts and pundits happy, or do you keep your powder dry and not listen - or at least not too closely - to the kind of speculation that drives the markets today?

Giving in to the latter means that you're giving in to the pressures of the market. And that's a bad idea as well: when markets call for massive increases in liquidity in order to avoid a market correction, for instance, it might make short-term sense to give in, but at significant long-term costs in terms of market expectations. In other words, helping markets avoid a downturn today may well mean that they will take an even greater downturn in 6 months' time, since the imbalances that have led to the downturn will not have been addressed, but rather merely postponed. Even worse, if the market believes that the Fed will behave in a certain manner, then there will be those who will try to leverage financial engineering to take advantage of lags in the market before the Fed can intervene, allowing massive profits at the cost of all players who don't play the same game plan, because the Fed has become predictable.

And that is why inflation targets are an abysmally bad idea.

The Fed needs to be predictable, but leave everyone guessing as to what it exactly plans to do. The decisions of the Fed need to be clear, but not with hard facts: this is the failure of the ECB. It can be predictable, but only in the sense that everyone knows that if the Fed thinks that growth is too low, it will reduce interest rates or adjust reserve requirements or use whatever tools it has too solve the problem.

Explicit inflation targets means that the Fed will have to pander to the markets: it will lose flexibility to proactively take measures.

And worse: the playing field willl be leveled. Now every pundit and wannabe will be able to state their case for believing or not believing what the Fed now explicitly states. That means that you'll have those out there who can claim to be better at guessing how markets and interest rates will move than the Fed, undermining the Fed's believability if the Fed doesn't get everything perfect.

Which it won't.

I don't like the move at all, and I think that Bernanke may well not go down in history as a worthy successor to Greenspan for the reasons enumerated here.


CasualReader hat gesagt…

Greenspan understood that inflation control was a byproduct of fiscal management. As you state, setting it as a target is foolhardy. Also, Greenspan understood the effect of increases in productivity and its effect on reducing inflation. I don't see the new guy appreciating this.

John F. Opie hat gesagt…

Hi casualreader -

You're absolutely correct, and the reason you give underscores how foolhardy it is to set inflation targets.

But I fear that the Fed will revert to its old ways of instigating recessions for obscure academic reasons...