Hamish McRae: Bernanke in danger of establishing a reputation for muddle

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The Independent Online

There is a difference between uncertainty and confusion. One of the tasks of any monetary authority is to maintain a sense of uncertainty in financial markets, for it is that uncertainty that creates room for the central bank to manoeuvre.

To achieve impact it needs to be able to surprise. But it should not surprise the markets unless it intends to do so. If it seems to be stumbling around, unintentionally surprising the markets, it just creates confusion. Central banks need the markets to think they know what they are doing, even if they don't know themselves.

The disillusion with Ben Bernanke, the new chairman of the Federal Reserve, seems in some measure to be associated with the fallout in financial markets in recent weeks. While it would not make sense to claim it is the major cause of these declines - why would emerging market share values be falling so fast if it were? - the general feeling is that the new chairman has done himself no favours.

In the last day or so, the financial markets have recovered a little, thanks probably to the easing of the oil price and the possibility of a deal with Iran over nuclear power. But the tetchy tone continues.

The immediate thing the markets will have to contend with this week will be the increase in eurozone interest rates today, for if there were no change that really would be a surprise. (Any change at the Bank of England would be an equal surprise, by the way.) But all eyes will soon switch to the next Federal Reserve decision, which will be on 29 June.

The background to this is that there are conflicting signals from the economy as to whether US interest rates, now at 5 per cent, need to rise further. On the one hand, inflationary pressures persist, unsurprisingly in view of the lagged impact of higher oil and commodity prices - though there is a dispute as to quite why prices are rising so fast. On the other hand, there are distinct signs that the economy is slowing, the latest being the payroll numbers last week, which were weaker than expected.

Against this background, you might imagine that the chairman of the Fed would keep pretty mum: a "we look at the data and make a decision" sort of thing. As it has turned out, he has made a couple of ill-judged comments.

One was telling a television journalist at a White House dinner that the markets had misunderstood some of his earlier testimony and that he was disappointed that they thought he was dove-ish on inflation. She duly filed the story, leading to a sharp fall in the markets and a row as to whether the comments were on the record or not.

The other was to reiterate his concerns about inflation last Monday, just after those weak payroll numbers, another comment that spooked the markets. The general feeling seems to be that if there are any bad inflation numbers next week, the Fed will have little option but to increase rates at the next meeting. It has boxed itself in.

But viewed in the round, the US has been very good at containing its current inflation. To take just one measure, unit labour costs are now rising by much less than they were in the 1990s and are close to zero now (see top graph). The principal inflationary worry, surely, comes from asset prices and in particular house prices (bottom graph.)

There are, I suggest, three different ways of looking at the dilemma facing Dr Bernanke. One is to focus on his "gaffe count", the way in which less-than-felicitous remarks lead to market swings: saying the wrong things. A second is to ask whether the present preoccupation with data is healthy and whether the figures chosen are the right ones: looking at the wrong things. And the third is whether the aim of central banking is too narrow. Instead of being preoccupied with inflation, central bankers should be more concerned about long-term stability: doing the wrong things. A word about each.

As far as Dr Bernanke's remarks are concerned, market operators always get cross when they lose money but they get particularly cross if they lose when they don't expect to. When they know a decision is coming - such as the next Fed one on interest rates on 29 June - they can plan for it. Similarly, they can prepare for appearances before Congress by Federal Reserve officials and be ready to interpret whatever testimony is given. But they are thrown when Fed chairmen go off-piste.

Does this really matter? Yes, a bit, because central banks need a reputation for judgement. They have only two weapons. One is a lever, control over short-term interest rates, which is pulled one way or the other all the time. The other is the emergency ability to meet a crisis by flooding the markets with liquidity. This they only do very occasionally.

So a lot of the time they have to operate by words, nudging the markets one way or another by giving a view about the national and the world economy. A reputation for muddle makes the whole job harder and Dr Bernanke is in danger of gaining one.

The second problem, though, is more important. The Fed is unusual in that it does not have a specific inflation target, for most central banks now use that as their main operating gauge. Keeping inflation within a range, or below a ceiling, is the main thing they are required to do. Here in the UK the inflation range gives a clear medium-term objective. The Fed's aim is more fuzzy, though Dr Bernanke is known to be a fan of inflation targets.

But while current inflation might seem a reasonable policy anchor, remember that this was chosen in the high-inflation days before China and (in the case of Europe) East European countries made a major impact on world trade and prices. The West's problems are over asset inflation, not current inflation. So not only is it silly to crawl over ever new statistics; the ones that central banks look at most closely matter much less than before.

That leads to a final point: what should be the long-term objective of central bankers?

It was clear that in the 1970s and 1980s it had to be fighting inflation because the double-digit annual price rises then threatened our entire civilisation. It was the greatest worldwide inflation ever known and it had to be stopped. But that is done. The main sources of instability now are financial imbalances and runaway asset prices. The first undermines the relationship between the US on the one hand and Asia on the other. The second increases inequality, for those with assets get richer at the expense of those without. Beyond the remit of central bankers? Well, no, since loose US monetary policy in the early 2000s contributed to both. Dr Bernanke's real problems are the ones he has inherited.