Chairman Bernanke’s claim is a great canard. The Fed is a serial bubble blower. Let’s first consider the Fed‐generated demand bubbles. The easiest way to do this is to measure the trend rate of growth in nominal final sales to U.S. purchasers and then examine the deviations from that trend. As the accompanying chart shows, nominal final sales grew at a 5.4% annual rate from the first quarter of 1987 through the third quarter of 2009. This reflects a combination of real sales growth of 3% and inflation of 2.4%.
The nominal final sales measure of aggregate demand contains three significant deviations from the trend (demand bubbles). The first followed the October 1987 stock market crash. The second followed the Asian financial crisis and the collapse of the Russian ruble and Long‐Term Capital Management in 1998. The last jump in nominal final sales was set off by the Fed’s liquidity injection to fend off a false deflation scare in 2002.
The Fed’s zigzag pattern is clear: an overreaction to a so‐called crisis, resulting in the excessive injection of liquidity (a sales boom), followed by a draining of liquidity and a recession (a sales slump).
The most recent aggregate demand bubble wasn’t the only one that the Fed was pumping up. As the accompanying chart of price indexes shows, the Fed’s favorite inflation target – consumer prices, less those for food and energy – was increasing at a regular, modest rate. Over the 2003–2009 period, this metric increased by 14.3%.
The Fed’s inflation target metric signaled “no problems.” But abrupt shifts in major relative prices were underfoot. Housing prices measured by the Case‐Shiller index were surging, increasing by 44.7% from the first quarter in 2003 until their peak in the first quarter of 2006. Share prices were also on a tear.
The most dramatic price increases were in the commodities. Measured by the Commodity Research Bureau’s spot index, commodity prices increased by 92.2% from the first quarter of 2003 until their peak in the second quarter of 2008.
The Fed should dust off the works of economists from the Austrian school, particularly Prof. Friedrich Hayek’s. The main lesson from the Austrians was their extreme skepticism about the exclusive reliance on one magic index – the price level – to guide central bank policy.
Indeed, Hayek stressed that changes in general price indexes don’t contain much useful information. He demonstrated that it was the divergent movements of different market prices during the business cycle that counted. It’s time for the Fed to dump inflation targeting.
Chairman Bernanke’s denial of the Fed’s culpability raises an interesting question: how can the Fed make fantastic claims without being brought to account? In a 1975 book of essays in honor of Prof. Milton Friedman, Capitalism and Freedom: Problems and Prospects, Prof. Gordon Tullock wrote: