Christina Romer: Empiricists and Theorists on Federal Reserve Policy
I would have put it differently--and less politely.
The Inflation Debate That’s Muting the Fed’s Response : Monetary policy makers are all hawks now. Even those who most emphasize the Fed’s role in fighting unemployment oppose policies that would raise inflation noticeably above the Fed’s implicit target of about 2 percent. The real division is not about the acceptable level of inflation, but about its causes, and the dispute is limiting the Fed’s aid to the economic recovery. The debate is between what I would describe as empiricists and theorists.
Empiricists... put most weight on the evidence... that the main determinants of inflation are past inflation and unemployment. Inflation rises when unemployment is below normal and falls when it is above normal. Though there is much debate about what level of unemployment is now normal, virtually no one doubts that at 9 percent, unemployment is well above it. With core inflation running at less than 1 percent, empiricists are therefore relatively unconcerned about inflation in the current environment.
Theorists... assume people are highly rational in forming expectations of future inflation.... Fed actions that call its commitment to low inflation into question can cause inflation expectations to spike, leading to actual increases in prices and wages. For theorists, any rise in an indicator of expected or future inflation, like the recent boom in commodity prices, suggests that the Fed’s credibility is at risk....
Now, not every monetary policy maker fits neatly into these categories. Most empiricists care about expectations of inflation and would hesitate to take extreme actions for fear that they would damage the Fed’s credibility. Some theorists oppose monetary expansion on other grounds, like the fear of setting off asset price bubbles. But the main division is between the empiricists who say “inflation is unlikely at 9 percent unemployment” and the theorists who say “inflation could bite us at any moment.”...
Most monetary policy makers agree that quantitative easing can stimulate the economy.... The fight over quantitative easing is about the costs. The empiricists say the policy won’t cause inflation because the economy remains so weak. The theorists argue that a small gain in growth could come at the price of a rapid rise in inflation.... As a confirmed empiricist, I am frustrated that the two sides have been able to agree only on painfully small additional aid for a very troubled economy. For a sense of how much more useful monetary policy could be, one can look to the Great Depression....
Franklin D. Roosevelt took the United States off the gold standard in April 1933, and rapid devaluation led to huge gold inflows and a large increase in the money supply. Roosevelt also made it clear that the monetary expansion would not be reversed. Expectations of deflation, which had been enormous, abated quickly. As a result, with nominal rates at zero, real interest rates (the nominal rate less expected inflation) plummeted. The first types of demand to recover were ones that were sensitive to interest rates. Automobile production, for example, jumped 42 percent from March to April in 1933. Inflation did pick up somewhat in the mid-1930s, in part because of other New Deal measures like the National Industrial Recovery Act. But the inflation was modest, and after the crushing deflation of the early 1930s, widely celebrated.
THE triumph of hawkish views on inflation means that there is no appetite today for a Roosevelt-style, inflationary monetary policy. But that doesn’t mean the Fed couldn’t be more aggressive if the empiricists were willing to risk a split with the theorists.
In a strongly worded article and speech several years ago, before he was Fed chairman, Ben S. Bernanke provided a user’s manual for responsible but unconventional monetary policy. Mr. Bernanke focused on Japan in the 1990s, but his recommendations could apply just as well to the United States today. The Fed could engage in much more aggressive quantitative easing, both in size and in scope, to further lower long-term interest rates and value of the dollar. It could more effectively convey to markets its intentions for the funds rate, which would also lower long-term rates. And it could set a price-level target, which, unlike an inflation target, calls for Fed policy to take past years’ price changes into account. That would lead the Fed to counteract some of the extremely low inflation during the recession with a more expansionary policy and lower real rates for a while.
All of these alternatives would be helpful and would retain the Fed’s credibility as a defender of price stability. And any would be better than doing too little just because some Fed policy makers believe in an unproven, theoretical view of how inflation works.