President Bush’s nomination of Ben Bernanke to head the Federal Reserve was initially welcomed by financial markets as the Dow Jones Industrial Average rose 169.78 points, the best rally since last June. The majority of market pundits anticipated his nomination, so the actual decision was a foregone conclusion. But the implication that Bernanke will follow in the footsteps of Chairman Greenspan most likely caused the market rally, inasmuch as the Greenspan years produced a substantial decline in inflation and interest rates.
Since 1982, some supply-siders have believed that the Fed shifted from a quantity rule for monetary policy to a price rule. In other words, the Fed gave up trying to control the supply of money, an approach recommended by Milton Friedman, and shifted to the use of one or more measures of inflation to guide the management of the fed funds rate to control inflation.
For the period between 1982 and the present, a lot can be said about the approach of Fed chairmen Paul Volcker and Greenspan to managing the economy and inflation through the implementation of a price rule. A careful analysis of the relationship between the price rule, inflation, interest rates, and the stock market reveals that a price rule for monetary policy has made a lot more sense than a quantity rule for money.
Meanwhile, commentary on how Bernanke will conduct monetary policy has seemed to revolve around a concept known as inflation targeting. This term is just another way of saying that the new chairman will follow in Greenspan’s footsteps of implementing a price rule, i.e. raising or lowering the fed funds rate to influence the course of inflation.
The continuation of a price rule by the new chairman has important implications for financial markets: Members of the Federal Reserve Board have voiced concerns over rising inflationary expectations. These concerns are being manifested in a policy of deliberate but steady increases in the fed funds rate. A Bernanke commitment to a price rule will continue the policy of taking the fed funds rate higher until there is a viable indication that inflation is falling.
By adopting a price rule for monetary policy (which I consider on par with inflation targeting), the Fed, by definition, must give up attempting to control the quantity of money. To implement a price rule, the Fed sets a fed funds rate target and then maintains that target in the normal course of monetary operations, where the Fed keeps the banking system in a modest “net borrowed” condition and then prices those needed reserves to achieve its target fed funds rate. The concept of helicopters dropping money over the country — i.e., running the money printing presses — has no application with floating exchange rates. The supply of money (reserves) is always a function of the immediate needs of the banking system. The Fed can control interest rates but it cannot alter “quantity.”
By adopting the price rule, the Fed also eschews more radical monetary policies that have failed under past chairmen of the Fed. For example, the Fed regulated the maximum interest rates payable on savings accounts. The implementation of this regulation, known as Regulation Q, produced a housing crisis in the late 1960s as money flowed out of savings institutions seeking higher yields in money market funds and other non-regulated investments.
A commitment by chairman Bernanke to a price rule either through policy statements or by observing changes in the fed funds rate relative to one or more inflation indicators should give financial markets greater confidence that the Fed remains committed to keeping inflation in check over the long-term. Given the probability that the Fed may have erred on the side of ease for too long — as indicated by the slow reaction of the Fed to rising inflation in 2004 — one can expect to see continued increases in the fed funds rate until the Fed is satisfied that inflation is no longer a threat.
– Thomas E. Nugent is executive vice president and chief investment officer of PlanMember Advisors, Inc. and principal of Victoria Capital Management, Inc.