Ben Bernanke: The US economy is underinflated; Fed finally gives 2% as target inflation rate

It happened.  The Federal reserve has finally stated their inflation objective of 2%.  Right now with inflation at 1%, the Federal reserve sees the US economy as underinflated.  Think about that when you buy groceries.  Now the policy that they are going to use is called Quantitative Easing, which is a fancy term for expanding the Federal Reserve Balance sheet through purchases of long term treasury securities.  The only question left is how much should they buy? 

I think the real mistake is having the Federal Reserve mandate of generating maximum employment, instead of just price stability.  It justifies tinkering by the Federal Reserve on a massive scale, unknown to Europe.  It also puts a lot of blame of employment on the backs of the guys setting the interest rates when labor regulations are much more pertinent.  I mean you have Spain, which has long term unemployment rates over 20% and Austria which is running about 5%.  It is clear that the legislative bodies have much more influence.  Full text of the speech via FRB:
The Federal Reserve has a statutory mandate to foster maximum employment and price stability, and explaining how we are working toward those goals plays a crucial role in our monetary policy strategy.
Recognizing the interactions between the two parts of our mandate, the FOMC has found it useful to frame our dual mandate in terms of the longer-run sustainable rate of unemployment and the mandate-consistent inflation rate.

...the mandate-consistent inflation rate--the inflation rate that best promotes our dual objectives in the long run--is not necessarily zero; indeed, Committee participants have generally judged that a modestly positive inflation rate over the longer run is most consistent with the dual mandate. (The view that policy should aim for an inflation rate modestly above zero is shared by virtually all central banks around the world.)

...The longer-run inflation projections in the SEP [Summary of Economic Projections] indicate that FOMC participants generally judge the mandate-consistent inflation rate to be about 2 percent or a bit below. In contrast, as I noted earlier, recent readings on underlying inflation have been approximately 1 percent. Thus, in effect, inflation is running at rates that are too low relative to the levels that the Committee judges to be most consistent with the Federal Reserve's dual mandate in the longer run. In particular, at current rates of inflation, the constraint imposed by the zero lower bound on nominal interest rates is too tight (the short-term real interest rate is too high, given the state of the economy), and the risk of deflation is higher than desirable.

Given that monetary policy works with a lag, the more relevant question is whether this situation is forecast to continue. In light of the recent decline in inflation, the degree of slack in the economy, and the relative stability of inflation expectations, it is reasonable to forecast that underlying inflation--setting aside the inevitable short-run volatility--will be less than the mandate-consistent inflation rate for some time. Of course, forecasts of inflation, as of other key economic variables, are uncertain and must be regularly updated with the arrival of new information.
Given the Committee's objectives, there would appear--all else being equal--to be a case for further action.

...Further policy accommodation is certainly possible even with the overnight interest rate at zero, but nonconventional policies have costs and limitations that must be taken into account in judging whether and how aggressively they should be used.

For example, a means of providing additional monetary stimulus, if warranted, would be to expand the Federal Reserve's holdings of longer-term securities.  Empirical evidence suggests that our previous program of securities purchases was successful in bringing down longer-term interest rates and thereby supporting the economic recovery. A similar program conducted by the Bank of England also appears to have had benefits.

Another concern associated with additional securities purchases is that substantial further expansion of the balance sheet could reduce public confidence in the Fed's ability to execute a smooth exit from its accommodative policies at the appropriate time. Even if unjustified, such a reduction in confidence might lead to an undesired increase in inflation expectations, to a level above the Committee's inflation objective. To address such concerns and to ensure that it can withdraw monetary accommodation smoothly at the appropriate time, the Federal Reserve has developed an array of new tools. With these tools in hand, I am confident that the FOMC will be able to tighten monetary conditions when warranted, even if the balance sheet remains considerably larger than normal at that time.

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