The markets appear pleased with the president’s nomination of Ben Bernanke to succeed Alan Greenspan as Federal Reserve chair next year. But the imminent retirement of the Maestro poses two types of problems for the financial markets.
In the short term, the risk is that the lame duck chairman will lose his effectiveness. We may have had a whiff of this at the last Open Market Committee (FOMC) meeting, when the vote for an increase in the fed funds rate was not unanimous. Few might recall that Paul Volcker’s departure from the Fed was accelerated when he lost an FOMC vote. Both Greenspan and Volcker ran tight ships, imperial Feds where unanimous votes were the norm. So, adding the Bernanke nomination to the mix, we may have the makings of a lame duck chairman and quite possibly an end to the Fed’s string of rate increases.
Longer term, other issues matter to the markets, such as whether or not anyone can reproduce Alan Greenspan’s record. At first, one may be tempted to answer no. But I’m not willing to concede the point. In fact, looking around the world, one can make the case that there are many countries and central banks that have produced Maestro-like results.
I have a theory as to the reason for this global success. In the cases where central banks have performed well, an explicit price-rule mandate has been in effect. The domestic version of this rule targets domestic inflation, and the international rule targets the exchange rate. The latter, while reducing and ultimately delivering low inflation (this occurred in China when it linked to the U.S. dollar and Spain when it linked to the EMU), does not solve the world inflation problem. The fixed-exchange-rate countries need to fix the underlying inflation rate to an anchor — and that anchor is the domestic price rule.
We know that Australia and the EMU have an explicit inflation-targeting rule. Looking at Australia’s experience during the last nine years and the EMU’s since the inception of the euro, one has to conclude that the monetary policy of these central banks is comparable to that of the U.S. Federal Reserve.
While it’s true that the Fed has never disclosed its operating procedure, I have pointed out over the years that its policy behavior is consistent with the domestic price rule. What’s more, I have argued that the U.S. inflation rate was consistent with a price rule even prior to the Greenspan years.
Here’s some strong evidence of this. In October of 1979, then-Fed chairman Paul Volker changed the central bank’s operating procedure. The Fed abandoned its targeting of monetary aggregates, and switched, in my view, to a domestic price rule or an inflation-targeting apparatus. The result was nothing short of spectacular. The inflation rate abruptly declined and more than two decades of relative price stability followed.
I also have argued that insofar as other countries have managed their exchange rates relative to the U.S. dollar, a global price rule anchored by the U.S. Fed would come about. My conclusion here is that the world inflation rate will converge to that of the U.S. inflation rate.
Alan Greenspan has done an outstanding job, but the success is not uniquely his. The price rule also deserves credit as it guarantees a low inflation rate both here and abroad. Therefore, as long as the next Fed chairman does not dismantle the current operating procedure (i.e., the domestic price rule), there is no reason to worry about the next Fed chairman.
More, the Bernanke appointment may in fact cure what many consider to be one of the major deficiencies of the Greenspan rule: Fed operating procedure is not formal and explicit. It will only take a few months and a crisis to find out whether or not the new chairman is up to the task of following the price rule.
As long as countries follow a strict price rule, the fluctuations in the traditional inflation indicators like commodity prices and monetary aggregates will reflect demand shifts and factors other than inflationary expectations. Therefore, the way to judge monetary policy is not by the behavior of the traditional inflation indicators, but rather by paying close attention to the core inflation rate or target rate.
The Bernanke standard promises to be the price rule’s third act. That’s quite bullish for America.
– Victor Canto, Ph.D., is the founder of La Jolla Economics, an economics research and consulting firm in La Jolla, California.