In my twenty years in this business, I have never favored the Fed adopting an explicit inflation target. I do now, as discussed last week in an essay co-authored with Goldman’s Bill Dudley, and published in the Financial Times. 1 As Bill and I wrote:

“The Fed should commit to keeping its federal funds rate at or below the current 1¼ per cent until core inflation climbs back to, say, 2 percent or higher on a year-on-year basis. The current reading of about 1½ percent (on Mr. Greenspan’s preferred measure, the core PCE deflator) is right in the middle of the 1-2 percent range that Ben Bernanke, Fed governor, recently suggested as the working definition of price stability.”

What made me change my mind, after a career of just saying no to explicit inflation targeting? The simple answer is the Fed’s secular war against inflation, commenced by Paul Volcker in 1979, has been won. We are now living in the promised land of price stability, and this neighborhood requires that the Fed build some anti-deflation credibility. An explicit inflation target, higher than the prevailing inflation rate, would be a very useful means towards that end.

The Fed Needs Both Anti-Inflation & Anti-Deflation Credibility
The figure is a line graph showing the year-over-year growth of the three-month moving average of the U.S. core PCE deflator, from 1960 to 2003. (PCE is Personal Consumption Expenditures, a measure of U.S. inflation.) From around 1996 onwards, the chart shows the deflator mostly fluctuating in the 1% to 2% range, which represents the Fed’s definition of price stability, and is highlighted with a gray, horizontal region on the chart. The deflator hadn’t been in the range since the mid-1960s. It shows to big peaks of close to 10% in the mid 1970s and early 1980s. From the early 1980s, it drops sharply down to around 4% by the mid-1980s, and fluctuates around that level until the early 1990s, when it starts to move down again to eventually meet the zone of price stability as defined by the Federal Reserve.

Me and Inflation Targeting
During the Fed’s anti-inflation campaign, I never favored an explicit inflation target, because I knew that if one were to be established, it would be set below the prevailing inflation rate. I thought that configuration would have been inconsistent with the Fed’s strategy of “opportunistic disflation,” in which it didn’t induce recessions to lower inflation, but welcomed them for their disinflationary dividends…kind of like losing 10 pounds opportunistically when hit with food poisoning. To my way of thinking, setting an explicit inflation target below the prevailing inflation would have implied a commitment to hit the target on some definable horizon, not just “opportunistically.”

Consequently, while the war against inflation was being fought, and in the context of the Fed’s legislated dual objectives of fostering price stability and full employment, I thought that an inflation target could/would cause more harm than good: it would beg questions about timing that could not be “opportunistically” answered, and would also imply that the goal of price stability dominated the goal of full employment. Thus, I thought that it would be wrong for the Fed to adopt an explicit inflation targeting regime. Don’t commit unless you are willing to deliver!

Anti-inflation credibility must be earned through deeds. And the Fed earned it during the 1980s and 1990s: opportunistically “taking” recessions when fate begot them, welcoming their disinflationary dividends, and then “locking in” those dividends via preemptive tightening in ensuing recoveries. The Fed delivered, and it did it Greenspan’s way, without an explicit inflation target, avoiding the negative externalities that are presently bedeviling the inflation-targeting European Central Bank.

I was especially critical of explicit inflation targeting as victory neared in the war against inflation, because success in that campaign was fostering bubbles in equity valuation, business investment and corporate leverage (irrational exuberance running on infectious greed, if you will). A bursting of those bubbles, just as the war against inflation was concluding, would open deflationary risk, I feared, and an explicit inflation target could/would be a straitjacket preventing aggressive, purposeful Fed reflation.

The Bernanke Put: The Wind Beneath Corporate Bond Wings
The figure is a line graph showing the spread of BBB corporate bond yields to U.S. Treasuries, from 1990 to 2003. Spreads average 151 basis points over the period, indicated by a horizontal line on the chart. The trajectory is U-shaped over the period, with a higher peak on the right side. Yet in 2003, spreads are in a free fall, approaching 200 basis points, down from a peak on the chart of about 350 basis points in late 2002. A vertical line in late 2002 indicates the date when the phrase “Bernanke put” is coined, on 21 November. The chart shows spreads at their lowest in 1997, at around 75 basis points. The other major peak is in 1991, when spreads are around 270.

Enter Ben Bernanke
Thus, I was a naysayer in 1999 when Fed Governor Ben Bernanke – then Professor Bernanke of Princeton University, and one of the world’s leading academic advocates of explicit inflation targeting – presented a widely-touted paper (co-written with Mark Gertler of New York University) at the Fed’s celebrated Jackson Hole confab. 2 Ben argued that an explicit (but flexible!) inflation-targeting regime was not only the right approach for the Fed in controlling inflation, but also that such a regime would obviate any need/reason to address directly the potential for asset bubbles: do nothing explicitly about them, he preached, because an inflation-targeting regime would automatically lead the Fed to lean against both the inflationary wind of inflating bubbles and the disinflationary whirlwind of deflating bubbles.

I thought this “let them be” approach to bubbles was particularly dangerous, turbo-charging my resistance to the notion of the Fed adopting an explicit inflation target. I believed then, and believe to this day, that bubbles and their bursting reflect not just human nature, which is given to fits of both irrational exuberance and irrational gloom, but also to policy mistakes. Ironically, however, I did agree with Professor Bernanke back in 1999 that the Fed should not explicitly hike its main macroeconomic policy tool, the Fed funds rate, in an explicit attempt to prick the self-feeding bubbles of equity valuation, business investment and corporate leverage.

I advocated that the Fed use its regulatory tools, notably its power to limit/prohibit buying stocks on margin. So, there was indeed a common thread in Bernanke’s view and mine: don’t use a macro tool to address a micro problem. A wise bartender doesn’t raise prices for the whole saloon to discipline a few rowdy drunks; he cuts them off!

As it turned out, of course, there were more than a few rambunctious souls intoxicated with New Age Economy hooch, mindlessly investing with mind-boggling leverage. While all that investing was going on, it was stimulating aggregate demand relative to aggregate supply, notably of labor, pushing down the unemployment rate – to and through the Fed’s presumption as to the NAIRU (non-accelerating inflation rate of unemployment).

So, the Fed tightened in 1999 and early 2000; the tightening was not, however, explicitly aimed at bursting the bubbles. Rather, it was consistent with what Professor Bernanke had advocated in August 99 at Jackson Hole: target inflation, and tighten if aggregate demand pushes unemployment below NAIRU (driving the “output gap” negative, in Taylor Rule formulation), without regard to whether a bubble is, or is not, propelling the “excess” aggregate demand.

Excess Demand Morphs Into Excess Supply
In the fullness of time, it did matter what was propelling “excess” aggregate demand, which was generating the “excess” demand for labor that had the Fed wrapped ‘round the inflation-risk axle. An investment boom is a source of aggregate demand while it is unfolding, but becomes a source of aggregate supply when it busts . In the end, an investment bubble is a deflationary shock, even though it appears, through a “conventional” Phillips Curve lens, to be the opposite while it is bubbling.

To Mr. Greenspan’s credit, indeed to the whole FOMC’s credit, the Fed recognized that the bursting investment bubble was a deflationary shock, and turned on a dime in late 2000 from a bias to tighten to a bias to ease, and then eased massively in 2001. It was the right thing to do. Whether or not the FOMC would have hesitated within an explicit inflation-targeting regime, we will never know. I suspect not, but I’m glad that the FOMC never even had to consider where the actual inflation rate was relative to some “billboard” inflation target. The Fed’s anti-inflation credibility was golden; it was time to start building some anti-deflation credibility!

Massive easing in 2001 spoke very loudly in this regard. But not loudly enough in 2002, as the full scope of the deflationary shock became visible, spooking both banks and the corporate bond market into freezing credit access to companies in the lower rungs of the investment grade universe. The Fed’s anti-deflation credibility was being called into question, and the Fed responded, in both deed and word: a 50-basis point cut in the Fed funds rate to a stunningly low 1 ¼%, and a full-blown rhetorical campaign as to the availability of “unconventional” weapons to attack the deflationary beast – and the Fed’s willingness to use them!

In a wonderful twist of fate, it was Ben Bernanke, newly confirmed as a Fed governor, who fired the rhetorical cannon heard ’round the world – his November 21 speech, “Deflation: Making Sure ‘It’ Doesn’t Happen Here”. 3 The speech followed on the heels of the Fed’s November 6 easing action, and Chairman Greenspan’s testimony before Congress on November 13 that the Fed had made the move in the context of wider “risk spreads on both investment-grade and non-investment-grade securities.”

Governor Bernanke’s “It” speech was the coup de grâce:

“…the U.S. government has a technology, called a printing press (or, today, its electronic equivalent), that allows it to produce as many U.S. dollars as it wishes at essentially no cost. By increasing the number of U.S. dollars in circulation, or even by credibly threatening to do so, the U.S. government can also reduce the value of a dollar in terms of goods and services, which is equivalent to raising the prices in dollars of those goods and services. We conclude that, under a paper-money system, a determined government can always generate higher spending and hence positive inflation.”

If a central banker wants to establish/re-establish anti-deflation credibility, bragging about his printing press is a very nice place to start! It was a masterful speech, and gave birth to what I dubbed the Bernanke Put: 4

“If lowering yields on longer-dated Treasury securities proved insufficient to restart spending, however, the Fed might next consider attempting to influence directly the yields on privately issued securities. Unlike some central banks, and barring changes to current law, the Fed is relatively restricted in its ability to buy private securities directly. However, the Fed does have broad powers to lend to the private sector indirectly via banks, through the discount window. Therefore a second policy option, complementary to operating in the markets for Treasury and agency debt, would be for the Fed to offer fixed-term loans to banks at low or zero interest, with a wide range of private assets (including, among others, corporate bonds, commercial paper, bank loans, and mortgages) deemed eligible as collateral. For example, the Fed might make 90-day or 180-day zero-interest loans to banks, taking corporate commercial paper of the same maturity as collateral. Pursued aggressively, such a program could significantly reduce liquidity and term premiums on the assets used as collateral. Reductions in these premiums would lower the cost of capital both to banks and the nonbank private sector, over and above the beneficial effect already conferred by lower interest rates on government securities.

It was a delicious moment: Ben, who had pounded the table against targeting asset prices at Jackson Hole in August 1999, preaching the doctrine of inflation-targeting as both necessary and sufficient to lean the right way against both bubbles and bursting bubbles, openly embraced targeting private sector debt prices, if necessary , to arrest deflationary pressures. A foolish consistency is the hobgoblin of small minds, Emerson told us a long time ago, and Ben Bernanke has got a big brain.

If/when the Fed’s problem is a lack of anti-deflation credibility, threatening/promising to use the printing press to “influence directly the yields on privately issued securities” is the right thing to do. Indeed, if the threat/promise is “credible,” then the Fed never has to ever actually use the printing press for that purpose!

Bottom Line
So far, the Bernanke Put has worked: it was a clarion call to buy corporate bonds, which haven’t looked back since, as shown in Figure 2 (not that Ben deserves all the credit!). The Fed’s anti-deflation credibility is now in a bull market. The Fed would be wise to solidify and strengthen that anti-deflation credibility by – you guessed it! – adopting an explicit inflation target that is higher than today’s inflation rate. In our Financial Times essay, Bill Dudley and I suggested “2% or higher” for the core PCE deflator, up from the current 1½% annual running rate. (Letting the cat out of the bag, Bill wrote “2%”; I wrote “or higher.”)

I don’t look for the Fed to adopt an explicit inflation target anytime soon, even though I believe firmly that the FOMC stealthily plans to “let” the inflation rate rise to 2% or higher, before it considers tightening policy.

My hope is that Chairman Greenspan uses his last few years to come ‘round to Governor Bernanke’s advocacy of quantifying just what “price stability” means, leaving behind a Fed rich in both anti-inflation and anti-deflation credibility.

If so, I’ll be pounding the table for putting Mr. Greenspan’s name on the building!

Paul A. McCulley
Managing Director
April 29, 2003




4 "Necking In The Mezzanine", December 2002.


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