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195 IRET Congressional Advisory 1 (2005)

handle is hein.taxfoundation/iretcgadv0192 and id is 1 raw text is: INSTITUTE FOR RESEARCH ON THE ECONOMICS OF TAXATION IRET is a non-profit 501 (c)(3) economic policy research and educational organization devoted to informing the public about policies thait will promote growth and efficient operation of the market economy. November 7, 2005 Advisory No. 195 MONETARY POLICY IN THE MONTHS AHEAD President Bush has nominated noted economist Ben Bernanke to succeed Alan Greenspan as Chairman of the Board of Governors of the Federal Reserve System. Dr. Bernanke has served as Chairman of the President's Council of Economic Advisers since June 2005. He was a member of the Fed board from 2002 to 2005, and was formerly professor of economics at Princeton University. Dr. Bernanke is an expert on monetary policy. He is a longtime advocate of inflation targeting, opposing both price inflation and deflation. Inflation targeting is the idea that the Federal Reserve should be charged with and held accountable for keeping inflation within some specified low range, for example, 1% to 1.5% annually. If inflation exceeds that rate, monetary policy would be tightened. If inflation falls to zero or less (deflation), policy would be eased. It is important that the Fed leadership focus primarily on maintaining a sound currency. Inflation is anti-growth, and depresses investment, productivity, wages, and employment. Inflation increases the taxation of income from capital. Capital consumption allowances (depreciation allowances) are strung out over many years and are not adjusted for inflation. When prices rise, the cost of capital is understated in real terms, business taxable income is overstated, and effective tax rates rise. Investment falters, dragging down employment and wages. Inflation, particularly at a variable and unpredictable rate, also creates uncertainty and risk, reducing the incentive to invest. It reduces the usefulness of the currency as a stable store of value and medium of exchange. In the case of the dollar, it would reduce the use of the currency in world trade, depriving the United States of the considerable advantages of creating the world's money and reducing the market for U.S. securities (in addition to raising interest rates on U.S. government debt). This view of the real anti-growth effects of inflation is contrary to the old Phillips curve view, which held that a little inflation could boost employment by tricking workers into accepting a lower real wage. Of course, the workers soon catch on, and they demand wages that keep up with prices. The presumed employment gains are wiped out, and are in fact offset by the damage done to investment and the demand for labor. While price stability should indeed be the principal goal of the Central Bank, it must be noted that hitting an inflation target is necessarily a somewhat long-term objective. Some flexibility is called for. Inflation numbers vary monthly. The core rate of inflation might be a better measure than more volatile alternatives. It may be several months before a trend in inflation becomes clear. The policy instruments that the Fed has at its disposal to curb inflation or offset deflation take time to work, and the economy responds to the available policy instruments in different degrees in different circumstances. Consequently, it is inherently difficult to know in the present what policy is needed to keep inflation tame in the future. There are several market signals that the Federal Reserve can watch to gain insight into where inflation may be heading. The current inflation rate is one sign, but it is the result of past Fed actions as well as recent economic factors. 8~*m k3. A * * g6~ I ~ee

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