Monday, October 23, 2006

What does Greg Ip have against the Treasury market anyway?

Greg Ip of the Wall Street Journal, who is a long rumored Fed mouth piece, has a piece out today saying the Fed could go on hold much longer than in the 1995 period. Regular readers of this blog know I've been making that case for a while now. Ip does bring something fresh to the conversation: how Bernanke's affinity for inflation targeting may influence his actions in ways that didn't Greenspan in 1995.

Under Greenspan, no one knew exactly what the Fed's tolerance was for inflation. Marketeers and policy makers could broadly agree that core CPI at 4%, as it was when Greenspan took over, was too high. But as former president of the Atlanta Fed Robert Forrestal said (quoted by Ip): "We talk about price stability and lower inflation, and inflation being quiescent, and so on, but I don't know what our level of tolerance is." Dr. Greenspan believed in judgment over econometrics. He believed the economy and markets were driven by emotional human beings. Check out this quote from a recent interview with Sherry Cooper of Nesbitt Burns.

"Ayn Rand showed me that my views were self-contradictory. From her, I learned that the economy is driven by psychology, values, attitudes, trust and other often-irrational and immeasurable factors. Rand showed me that judgment is a key ingredient in all economic forecasting and analysis. One cannot understand society as a whole unless you deal with all of it. Economics is more than a technical field. It is based on the whole spectrum of human decision-making and action. Econometrics is only part of the game. A good example of this is that to complete economic transactions, people must trust the word of strangers. This works because it's practical. I would likely have been a reclusive econometrician, spitting out bad forecasts, if it weren't for Ayn Rand."

So if we follow Greenspan's idea of judgment over rigid rules, it stands to reason that he'd not want to give hard numbers on where he wanted inflation to be.

Bernanke is a man of evidence. The evidence points strongly to the value of inflation targeting. Read this panel discussion from the summer of 2004: it's a roadmap to how Bernanke is operating today. So while it might be politically sensitive for the Fed to create a statutory inflation target, de facto, we already have one. As soon as Fed economists publicly start throwing around ranges like 1.5% to 2.5%, for all intents and purposes, that's the inflation target.

For what its worth, I am a man of evidence as well. I've read the evidence for and against inflation targeting, and I find the evidence favors the target. But really, for someone in my profession, its besides the point as to whether the inflation target is good for the economy in the long run. The fact is, for the near term at least, the Fed is going to focus on keeping core PCE between 1.5% and 2.5%.

So to bet that the Fed is going to act like it did in 1995 is to assume that two very different philosophies about how to run the Fed will come to the same conclusion. If that happens, then it will be by coincidence. 1995, in my mind, should clearly not be used as evidence for what's going to happen in 2007.