The Fed: Bernanke proposes Fed adopt ‘temporary’ price-level targeting to combat next recession

Former Federal Reserve Board Chairman Ben Bernanke

The man who guided the Federal Reserve through the Great Recession thinks the central bank needs new tools to get the U.S. economy through the next downturn.

In a blog post and a speech at the Peterson Institute for International Economics on Thursday, former Fed chair Ben Bernanke said the central bank should adopt “temporary” price-level targeting when interest rates next get stuck at zero.

Under price-level targeting, the Fed would commit to have inflation average 2% over time. So the central bank would allowing inflation to remain above 2% to “make up” for periods when inflation is too low.

What to do when interest rates get to zero has been debated because economists think it will not be uncommon.

To combat recessions in the past, the Fed would slash interest rates, often by 4 percentage points or more, to help the economy recover. But there is little room to do that now as the Fed’s interest rate target is barely over 1%.

Under the Fed’s current playbook, the central bank would cut rates to zero, give guidance that rates would stay low, and then consider whether to engage in quantitative easing or bond buying.

With price-level targeting, the market would know the Fed was committed to keep rates lower-for-longer — until inflation returned well above 2%, Bernanke said.

Today, the U.S. central bank follows an inflation-targeting approach — setting the target rate at 2%. Under the current strategy, even though inflation has been below the Fed’s target since 2012, the central bank still intends to hit the 2% target going forward.

Price-level targeting has not been popular because it comes with a downside. The Fed would not be able “to look through” a temporary supply shock. The Fed would have to tighten policy if there was a spike in the price of oil.

To get around this, the Fed would keep a 2% inflation target during normal times, Bernanke said.

Bernanke said his approach would be better than raising the Fed’s inflation target to 4%.

While this would give the Fed more space to cut rates during a downturn, a 4% inflation rate would be unpopular with the public and lawmakers.

In a panel discussion after Bernanke’s speech, Fed Gov. Lael Brainard said one problem with the proposal was to figure out when Fed policy would revert to the “standard” 2% inflation target.

In theory, the standard rule would likely kick in when the economy was at full employment and inflation was well above 2%. This could result in a “relatively sharp path of tightening” could undo some of the benefits of the new framework, she said.

Another concern was a risk of asset bubbles that might develop if the Fed kept interest rates low for longer.

“The combination of low interest rates and low unemployment that would prevail during the inflation overshooting period could well spark capital markets to overextend, leading to financial imbalances. Markets might overshoot,” Brainard said.

While regulatory tools are the preferred first line of defense to address bubbles, they remain “relatively untested” in the U.S., she noted.