The Most Important Ben Bernanke Speech That No One Heard

BOSTON (TheStreet) -- When earnings reports from Apple (AAPL), Bank of America (BAC) and Goldman Sachs (GS) captivated Wall Street and dominated headlines Tuesday, Federal Reserve Chairman Ben Bernanke was speaking at the uncelebratory 56th Economic Conference in Boston.

Federal Reserve Chairman Ben Bernanke

Across the street from the Boston Federal Reserve, Occupy Boston demonstrators asked Bernanke to appear at the protest and speak with them, an invitation he declined. But what the Fed chairman hinted at during the conference, overshadowed by the day's earnings releases and gloomy news from Europe, bears more attention than it received, especially from the protestors.

"With respect to monetary policy, the basic principles of flexible inflation targeting -- the commitment to a medium-term inflation objective, the flexibility to address deviations from full employment, and an emphasis on communication and transparency -- seem destined to survive," Bernanke said in his speech.

Though his comments appear innocuous, some investors and economists are wondering whether he was suggesting that the Fed, which has primarily targeted inflation for monetary policy, would instead target nominal gross domestic product, or NGDP. Bill Gross, who manages the world's biggest bond fund at Pimco, tweeted that "Bernanke's emphasis on 'communications' is likely code for 'targeting' nominal GDP or unemployment."

The central bank for two decades has adhered to the Taylor Rule, which says the Fed should raise interest rates along with increases in inflation. The possibility of shifting away from inflation targeting toward a goal that targets the output gap is a big step for the central bank, and its ramifications for the economy and politics in a presidential-election year would be a game-changer.

"This was a seminal speech for Bernanke," says Diane Swonk, an economist with Chicago-based Mesirow Financial. "There wasn't as much attention called to this speech as there should have been."

While it's true the Fed already has a dual mandate to keep inflation in check and seek to sustain full employment, a change would mean the Fed could better react to economic shocks, such as bank failures or sovereign defaults. The Economist summed up the idea of the Fed changing targets in April:

Advocates of nominal GDP targeting claim that it would achieve greater macroeconomic stability. When recession hits, real output falls but prices tend to adjust more slowly. This means that by targeting nominal GDP, central banks could actually smooth output fluctuations better. They could also react more appropriately to supply shocks.

"It would be a big step for the Fed," says Ryan Sweet, a senior economist at Moody's Analytics. "There seems to be gathering a lot of support. Given where the economy is right now, it could provide a boost. That said, it's unclear what the economic impact will be. In theory, it would help the economy perform better, but I don't know the Fed wants to go down that road this year."

Targeting nominal GDP has been garnering support. Last weekend, Goldman Sachs' U.S. economic analyst Jan Hatzius said that "the best way for Fed officials to ease policy significantly further would be to target a nominal GDP path," which would result in "additional asset purchases to help bring actual nominal GDP back to trend over time."

To illustrate the point, Hatzius offered a chart that shows actual nominal GDP is 10% below the trend line of nominal GDP prior to the financial crisis in late 2008. The easily graspable idea that we need to return to the trend line is something that would resonate with Americans who may not know the intricacies of monetary policy, economists says.

"People understand it better," Swonk says. "What Ben Bernanke is laying the groundwork for is a different kind of targeting. If you target the unemployment rate, you'd tolerate a little higher inflation for a while. But you need to change people's view of it. It's a subtle difference to target nominal GDP, but in the message it's something that markets can understand if you say we're trying to recoup the losses."

Swonk says the move would make sense because now, even with a dual mandate, the Fed would tighten interest rates if inflation gets too high. The fear that the Fed will raise rates at the first sign of faster inflation has kept investors in Treasuries and out of more productive investments for fear the economy could collapse again.

The Fed has already taken drastic steps to change that notion. The Federal Open Market Committee has said it would anchor interest rates near zero until mid-2013. That was followed by Operation Twist, in which the central bank said it will take maturing short-term Treasuries and invest the money in longer-term notes, drive yields lower.

"The idea is to fix expectations of the future so people know they'll have some certainty in the environment," Swonk says. "The Fed is showing they'll be there to help recoup the losses in GDP and they won't take the punchbowl away too soon."

Moving the target from inflation to NGDP is one thing, but executing it is another. The Fed would still have the same tools at its disposal, so what can it do differently? A solution would be another round of quantitative easing, in which the Fed expands its balance sheet to buy long-dated U.S. Treasuries, pushing interest rates even lower.

"The Fed's forecast has medium-term inflation too low, which implies that the Fed has to keep easing," Swonk says. "That could mean quantitative easing, but my guess is they'll first try to play more with expectations. The mid-2013 goal with interest rates was the first step in that."

Further quantitative easing, which would be branded as QE3, is already a political hot topic. While the FOMC was in a two-day meeting before Operation Twist was announced in September, high-ranking GOP officials sent a letter to Bernanke urging no further monetary stimulus. New Fed targets would set off a firestorm.

"There's going to be an economic debate, whether this works or not, and that's legitimate," Swonk says. "But the political debate, saying the Fed can't stimulate the economy because it might help Obama, well, that's not the Fed's job. Frankly, they're the only ones in Washington thinking about the long-term economy. They'll do whatever they need to do. The Fed takes pride in its chairmen not being loved by politicians. They have to continue to act as independent and credible as they can."

Some investors oppose nominal GDP targeting. Michael Pento, president of Pento Portfolio Strategies, argues that increasing the rate of inflation raises the rate of unemployment.

"Every time the Fed has increased the money supply and sent prices rising, the rate of unemployment has risen, not decreased," Pento writes in an email. "The simple reason for this is that inflation diminishes the purchasing power of most consumers. Falling real wages means less discretionary purchases can be made. Falling demand leads to increased layoffs and the unemployment rate rises as economic growth falters."

With the next FOMC meeting on interest rates scheduled for Nov. 1 and 2, there will be speculation over what Bernanke and Co. will say and, perhaps more importantly, how they will say it. For that reason, Moody's Analytics' Sweet says Bernanke was right to speak on Tuesday in Boston about how the Fed will communicate their decisions more effectively.

"They're going to need to improve upon that if they're going to go for a NGDP target," Sweet says. "That said, a NGDP target would be easier than a higher inflation rate. That would be a much harder sell for the Fed. With NGDP, they can say they're targeting higher employment, income and production, rather than saying they want higher inflation."

-- Written by Robert Holmes in Boston.

>To contact the writer of this article, click here: Robert Holmes.

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