Bernanke’s latest monetary policy framework isn’t novel – it’s 90 years old For Professional Investors Only

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Recently Ben Bernanke proposed a new framework for inflation targeting and monetary policy setting when interest rates are at the zero-lower bound (ZLB), exploring the idea that the Federal Reserve (Fed) should aim at price-level targets rather than inflation rates. Bernanke is at pains to stress that ‘…nothing in this blog post or my paper should be taken as a commentary on current Fed policy’. But, of course, when somebody as influential as Ben Bernanke is proposing a complete redrafting of the monetary policy world order, then people should take note. It’s an excellent speech and well worth a read.

Alongside independence, inflation-targeting is arguably the second most internationally recognised norm for central banks to have emerged over the last 50 years. Almost every developed market’s central bank has an inflation target (among other objectives), which guides monetary policy.

Since the Global Financial Crisis, new tools and methods have emerged to be tested by central banks. Quantitative easing, negative rates and macro prudential policy have all diffused across the community of central bankers in order to get inflation to target. Given some of the problems with (unconventional) monetary policy experimentation, academics have begun proposing changing not the tools, but the framework.

As opposed to inflation targeting, price-level targeting aims to ‘keep the level of prices on a steady growth path, rising by (say) 2 percent per year; in other words, a price-level-targeter tries to keep the very-long-run average inflation rate at 2 percent.’ What this means is that bygones are not bygones – if the central bank misses inflation by 1% one year, it must aim for 3% next year in order to reach its price-level target.

The reasoning for this framework, Bernanke proposes, is that the price-level target would lead to more credible market expectations of a ‘lower for longer’ rate-setting strategy, and this expectation of loose monetary policy and faster rates of growth would mitigate declines in output and inflation during the period in which the ZLB is binding, thereby also reducing the period in which the ZLB is in effect.

As novel as this idea seems, it has been tried before by the bastion of monetary policy experimentation – the Swedish Central bank, known to Swedes as ‘The Sveriges Riksbank’. The Riksbank has a long history of being first. Established in 1668, it is widely considered the oldest central bank. In 2009, it was the first central bank to implement negative interest rates, when it moved its deposit rate to -0.25%. The Riksbank also remains the only central bank to ever have attempted price-level targeting – back in 1931.

Much like Bernanke’s proposal, the price-level targeting of the 1930s Riksbank was also meant to be a temporary objective in times of crisis. The initial purpose of the 1930s policy was to bridge the gap until Sweden could return to the Gold Standard.

A common argument surrounding the causes of the Great Depression supports that the effects were exacerbated by the international gold standard. By linking their currencies to gold, countries ensured that the global money supply would only increase in line with newly mined metal. With the sterilisation of reserves in France and the US in the late 1920s, the monetary base began to contract relative to GDP growth, helping to spread deflation around the world. Once diagnosed, several countries began to leave the gold standard in the early 1930s, which then contributed to inflation picking up again dramatically as these countries’ currencies saw large depreciations. At the announcement in the Autumn of 1931 that Sweden was leaving the gold standard, a new target of price stabilisation was announced – in one sentence at the end of the declaration.
This sentence was to evolve into a monetary program over the next months. Following the huge gyrations in inflation rates witnessed by other countries following their leaving the gold standard, the Swedish Finance Minister announced that monetary policy should be directed at ‘preserving the domestic purchasing power of the Swedish krona’ in order to put a stop to the deflationary spiral, as well as to calm fears that a sharp return to previous price levels would eat into Swedes’ spending power. The target level was to maintain the cost of living (CPI) as it was in September 1931. There was disagreement among academics about whether producer (wholesale) prices, which had seen a far greater fall, should be allowed to appreciate from their low levels.

Exchange Rate Krona/Pound
(1928-1930 annual data, 1931-1938 monthly data)

Source: C. Berg, L. Jonung/Journal of Monetary Economics (1998); Ekonomisk Oversikt 1932-1940.

This new policy involved the Riksbank having to calculate a consumer price index on a weekly basis, in order to gauge both the direction of policy, and to monitor its results. The new framework was approved in Parliament in 1932.

So, how well did the experiment work? Following a government review in 1933, several notable Swedish economists noted that the consumer price index had displayed a high degree of stability, particularly in light of the previous extent of deflation.

As the chart below demonstrates, the Riksbank helped stabilise Swedish prices following the new policy announcement. The move off the gold standard, leading to a sharp devaluation of the krona, was met with a spike in the bank rate to offset inflationary pressures, before this was then reduced to meet the price target. Modern commentators suggest that Sweden’s experimental monetary policy was a key factor in Sweden’s recovery from the Great Depression, certainly outperforming those that remained on the gold standard beyond 1931.

Wholesale price index and the consumer price index of the Riksbank

Source: C. Berg, L. Jonung/Journal of Monetary Economics (1998); Riksbank.

Comment: the quarterly cost-of-living index for 1928-1930 has been interpolated and linked to the monthly consumer price index of the Riksbank starting in January 1931.

Bank Rate
(1928-1930 annual data, 1931-1938 monthly data)

Source: C. Berg, L. Jonung/Journal of Monetary Economics (1998); Ekonomisk Oversikt 1932-1940.

Swedish politicians at the time, however, thought more could have been done with a different framework, among them a focus on employment stabilisation and the emerging Keynesian school of linking monetary policy to countercyclical fiscal policy. A second evaluation of the policy occurred in 1937, in which the Board of Directors looked to change the policy objective given changing economic circumstances and ideas. Wholesale prices had returned to their level before the depression, while CPI had moved broadly sideways as the target dictated. In 1937, the Riksbank was tasked with additional responsibilities, and the world’s first experiment with price-level targeting began merging into a more synchronised economic program for the country.

The Swedish experience suggests that a price-level target can be somewhat achievable, although the circumstance was certainly different. The goal for the Riksbank could have been further clarified (it had more than one target variable), more goals were added over the course of the program, the deposit rate was the main tool readily available to use, the Riksbank was active in the FX markets, and central bank practices of communication and forward guidance were far from what we see today (although ahead of their time for that period). The lack of complete independence also influenced rate-setting policy. Nonetheless this was a period of experimentation, which was arguably effective.

Perhaps more crucial to the debate on price-level targeting are the flaws that one could see with such a system based on expectations and such rigid targets in a globalised economy. If inflation remains below target for a few years due to an external shock, what does this mean for the central bank? Does the Federal Reserve still retain the credibility of the market to meet its target? Do markets expect inflation to reach, say, 5.5% next year? Do bond markets reprice and yields rise, or do negative real yields remain at -5.5%? If the former, is credit still available for the economy? If the latter, what does that mean for US consumption and growth rates? Does the Federal Reserve lose influence over inflation expectations? Would the Fed move rates away from the ZLB simply to unburden themselves from their price-level target? Given the unintended consequences of negative rates on the financial system, it’s easy to see how unknown unknowns would exist, could emerge, and ultimately have huge negative effects.

We are probably far from seeing changes to the Fed’s mandate, if ever, but proposals from former central bankers cannot simply be ignored. To leave you with a quote from Keynes himself:

“The ideas of economists and political philosophers, both when they are right and when they are wrong, are more powerful than is commonly understood. Indeed the world is ruled by little else. Practical men, who believe themselves to be quite exempt from any intellectual influence, are usually the slaves of some defunct economist.”

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