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Rethinking the Fed

Influential Fed governor Ben Bernanke contends that the bank doesn't communicate enough and ought to set inflation targets. Defining the post-Greenspan era has begun.

Like the dog that didn't bark, the outspoken Ben Bernanke conspicuously didn't give a speech at this summer's powwow for movers and shakers in finance and academia in Jackson Hole, Wyoming, sponsored by the Kansas City Federal Reserve Bank. But it is in large part a testament to the growing influence of Federal Reserve Board governor Bernanke that the central bank's powerful chairman, Alan Greenspan, devoted his keynote speech to defending a flexible approach to monetary policy.

The Fed must practice "risk management," Greenspan declared, so it needs maximum discretion in monetary policy to contend with financial crises. Bernanke, who until joining the seven-person Fed board in August 2002 chaired Princeton University's economics department, is an ardent proponent of central bank inflation-targeting: publicly declaring the Fed's inflation objective to make monetary policy more predictable. Greenspan and his allies on the Fed board argue that this could undermine the chairman's maximum-discretion doctrine.

It will take more than one speech to put Bernanke in his place, however. "He is an independent thinker and because of his stature is providing intellectual leadership inside and outside the Fed," says former Fed governor Laurence Meyer, who also favors an explicit inflation target. Former Fed vice chairman Alan Blinder, an advocate, like Bernanke, of the Fed's being more forthcoming about its objectives, notes that the former Princeton professor has assumed "the role of the classical academic. He's also a big believer in central bank transparency, and believers in transparency tend to speak out more."

Indeed, shaking up the Fed is Bernanke's mission and, seemingly, that of the Bush administration. Explains R. Glenn Hubbard, who as chairman of President George W. Bush's Council of Economic Advisers recommended Bernanke for the job, "I felt the Fed board needed a prominent economist and also that it was important to introduce new ideas and have them debated."

The current chairman of the council, N. Gregory Mankiw, offers this perspective: "It seems very important to have a group of very talented people at the Fed, people with the heft to think outside the box, and Bernanke has been very effective in that role."

The bearded Bernanke has begun the process of redefining the U.S. central bank as the long and mostly distinguished tenure of the 77-year-old Greenspan ineluctably winds down. Although President Bush has said that he would renominate Greenspan to another four-year term as Fed chairman, most observers expect Greenspan to step down sometime after next year's presidential election, probably in 2005.

Bernanke tells Institutional Investor that he doesn't see himself as a troublemaker. "I joined the Fed board," he says, "because I wanted to be constructive, because I wanted to bring whatever insights I had to help make monetary policy better." Nevertheless, Bernanke is closely identified with two intertwined causes that could have a major impact on the way the Fed conducts its business in the post-Greenspan period, if not sooner: inflation-targeting and greater transparency. And because of this summer's bond market turmoil -- the worst in two decades -- the Fed governor's call for the central bank to be more explicit about its inflation goals as well as less reticent about both its deliberations and its actions is gaining a more receptive audience among market participants and independent economists. As former Bush economic adviser Hubbard, now teaching at Columbia University, says, "My fear is that you don't want unlimited Fed discretion because markets don't know what to expect, and while discretion has been fine with Greenspan in charge, he won't be there forever."

Bernanke is winning important allies within the Fed. One of his key confederates is St. Louis Fed president William Poole, who endorses the central bank's publicly declaring an acceptable range for inflation. "What we are trying to do is push in the direction of clearer market understanding of policy, and inflation-targeting is part of that," Poole told II early last month. J. Alfred Broaddus Jr., president of the Richmond Fed, also supports inflation-targeting.

Bernanke is being careful to avoid alienating those who disagree with him, especially Greenspan. Although Bernanke and the chairman have their intellectual differences, their relationship remains a mutually respectful one. And Bernanke has gone out of his way to publicly support Greenspan on issues on which they both agree. Last month the Fed governor made a series of speeches based on his own research that backed up Greenspan's contention that monetary policy isn't a good tool for deflating a stock market bubble.

Bernanke's mounting influence at the Fed stems not just from his authority as an expert on monetary policy but also from his knack for setting out complex economic arguments convincingly. "Bernanke's views are relevant beyond just one vote because he is able to persuade others of his point of view," notes Avinash Persaud, former head of research at State Street Global Markets, who now manages a currency fund for UBS Global Asset Management.

In many ways, Bernanke, 49, makes an unlikely pot-stirrer. As a Jewish kid in Dillon, South Carolina, where his father was a pharmacist-cum-theater-manager and his mother a schoolteacher, he grew up feeling like something of an outsider and accordingly was extremely shy, say friends. Bernanke showed academic promise, however, winning the state spelling bee when he was in the sixth grade. He earned his BA summa cum laude from Harvard University in 1975, then received a doctorate in economics from the Massachusetts Institute of Technology in 1979. (His thesis was on how uncertainty delays investments.)

As a young professor of economics at Stanford University's Graduate School of Business, Bernanke, having overcome his shyness, quickly developed a reputation as a superstar teacher because of his ability to explain difficult concepts clearly -- a skill that he has put to good use at the Fed. But Bernanke's standing within the economics profession got its biggest boost in 1983 when he published a paper in the prestigious American Economic Review on the causes of the Great Depression revolutionized the topic and remains the definitive account of this dismal episode in central bank history.

Nobelist Milton Friedman and his colleague Anna Schwartz had set out the conventional wisdom about the Great Depression -- that it was chiefly caused by the Fed's decision not to provide liquidity after the 1929 stock market crash. Bernanke went a step further, arguing that what really precipitated the Great Depression was the Fed's failure to deal with a postcrash banking crisis.

"Bernanke was a star in the Ph.D. market and gained fame with the paper," says Mark Gertler, chair of the economics department at New York University and co-author of numerous articles with Bernanke. Adds Gertler with a chuckle, "I can't think of better preparation for being on the Fed board than to have written about the Great Depression." In one of his first speeches as a Fed governor, Bernanke acknowledged -- and apologized for -- the bank's role in the Great Depression.

Bernanke was appointed a full professor at Princeton in 1985. Along the way to becoming chairman of the economics department in 1996, he built a reputation as a leading macroeconomist. He was a visiting scholar at the Federal Reserve Banks of Philadelphia, Boston and New York, published dozens of articles, helped to edit a number of academic journals and wrote several books -- including one on inflation-targeting. He served as head of the monetary economics program of the National Bureau of Economic Research and was a member of NBER's business-cycle-dating committee. In 2001 he was named editor of the American Economic Review.

Bernanke earned favorable notices outside academia in August 1999 when he first addressed the Jackson Hole confab. It was the perfect setting for his debut on a wider stage. A star-studded event in the world of finance, its by-invitation-only participants include senior central bankers -- Greenspan among them -- and academic economists and policymakers from around the world, who gather for two days of presentations, discussions and hobnobbing at the Jackson Lake Lodge, in the shadow of the Grand Tetons.

At the time, the U.S. stock market was in the final months of an unprecedented boom. Bernanke dazzled the crowd with a prescient paper on how central bankers should deal with asset price bubbles. They should not even try, he contended, because inflation -- not stock prices -- is the proper focus of monetary policy. But once a stock market bubble bursts, the Fed should quickly lower interest rates to avoid the greater risk of deflation. "The paper was the policy application of all our academic work over the years," says NYU's Gertler, who co-wrote the Jackson Hole paper. Their reasoning has become accepted wisdom within the Fed and in fact guided the central bank in the aftermath of the bubble's bursting, when it cut rates sharply.

To their surprise, Bernanke and Gertler set off a small media storm -- they even found their picture in theNew York Times. Journalists and many academics interpreted the paper as a vindication of Greenspan's decision not to try and prick the U.S. stock market bubble.

Over the years Bernanke has polished his public persona, and today the once painfully shy young man can seem positively gregarious at times. Riding herd on big egos as head of Princeton's economics department for six years no doubt helped him to hone his diplomatic skills, as did a two-year stint on New Jersey's Montgomery Township school board.

Bernanke's wife, Anna, teaches Spanish at the Princeton Day School. They have a son at Brown University and a daughter in the 12th grade in Princeton. Once their daughter finishes high school, Anna will join Bernanke in Washington, but in the meantime, he returns home to Princeton on the weekends, a commute that he complains is wearing. An old Princeton colleague, former International Monetary Fund chief economist Kenneth Rogoff, who now teaches at Harvard University, says, "For a lot of people, being editor of the American Economic Review would have been crippling, yet Ben still found time to be on the school board."

When two slots opened on the Fed board last year, Bernanke surfaced at the top of the Bush administration's list of replacement candidates. His obvious credentials as an expert on monetary policy (and a registered Republican) appealed to Hubbard as well as to then­assistant secretary of the Treasury for economic policy Richard Clarida. "Bernanke was recommended by Hubbard, who wanted to raise the stature of the Fed board," says Gertler.

Known more as an economist's economist than an ideologue, Bernanke does not flaunt his political views. Indeed, his friends and colleagues purport not to know where he stands on many issues. His perspective tends toward scholarly dispassion. For instance, Bernanke tells II that Bush's 2001 tax cuts helped support consumer spending that year and the next one, but he also stresses how important it is for the federal government to maintain a long-run fiscal balance, especially as baby boomers get ready to retire.

For the other spot on the Fed board, the administration took the unusual step of choosing a Fed insider, Donald Kohn, a Greenspan protégé and longtime senior staffer of the central bank who is viewed as a counterweight to Bernanke. Kohn, like Bernanke, is well respected for his expertise in monetary economics, but unlike Bernanke, he is a stout defender of Greenspan's "trust me" style of policymaking. Kohn's term ends in 2016. Initially appointed to serve out an unexpired term ending in January 2004, Bernanke was nominated by President Bush in September to a full 14-year term and is expected to be confirmed by the Senate by midmonth.

Bernanke's and Kohn's expertise in monetary policy appealed to the administration because the Fed board was light on economists and heavy on market and banking specialists. Vice chairman Roger Ferguson Jr. is an expert on financial institutions, governors Susan Schmidt Bies and Mark Olson are banking mavens, and their peer Edward Gramlich focuses on public finance. "At this point the board is very nicely diversified," says Bernanke. "There's somebody who is strong in each area, so everybody has got their own area of expertise, and everybody has got a role to play."

As likely as not, they have an opinion to sound off on. Each Fed board member is free to express his or her opinions in public speeches as well as through research papers. Most do. And it's not just the seven governors, Greenspan included, who convey signals, intentionally or otherwise, to the financial markets. The central bank's Federal Open Market Committee, which meets eight times a year to vote on interest rates, consists of the seven Fed governors plus the head of the New York Fed and the presidents of four of the remaining 11 regional Fed banks, who serve on a rotating basis. Bond traders, then, must pay heed in various degrees to no fewer than 19 voices -- those of seven Fed governors and 12 regional bank presidents.

Bernanke's critics would say his contention that the multivoiced Fed needs to communicate more clearly ought to begin with him. "Bernanke has become an important figure but has reduced the credibility of the Fed overall," grumbles one primary dealer.

The episode that provoked such disgruntlement is last summer's big bond sell-off, the result in large part of undeniable miscommunication by Fed officials, not least Bernanke. The story of the bond debacle has been told before (Institutional Investor, September 2003), but Bernanke's take on events provides a fresh perspective -- and reinforces his case for more transparency.

In November 2002, only months after being named a Fed governor, Bernanke spoke at the National Economics Club in Washington on the postbubble risks of disinflation or even deflation. He sought to reassure the markets that the central bank would not be impotent to act against potentially falling prices, even with interest rates already approaching record lows. The U.S. government, Bernanke pointed out, "has a technology called a printing press, or today its electronic equivalent, that allows it to produce as many U.S. dollars as it wishes at essentially no cost. . . . Under a paper-money system, a determined government can always generate higher spending and hence positive inflation." What's more, he said, the Fed also had "unconventional" tools at its disposal to keep deflation at bay, such as lending directly to banks, engineering a fall in the dollar or buying up long Treasury bonds.

Bernanke's remarks set the markets abuzz. Traders began loading up on Treasuries, figuring that the Fed was becoming so worried about the deflation threat that is was bound to lower interest rates still further, driving up bond prices. Fed expert Paul McCulley of giant bond fund company Pimco coined the phrase "Bernanke put" to describe this new Fed antideflation policy, because it seemed to put a floor on the market.

Bernanke's speech, coupled with one by Greenspan four weeks later that echoed many of the same themes, changed the markets' mind-set. This past March the Treasury futures market showed that inflation expectations had increased by more than 60 basis points.

But the deflation bandwagon gained more momentum in May when the Fed, while holding interest rates steady at 1.25 percent, nonetheless pointedly warned that the "probability of an unwelcome substantial fall in inflation, though minor, exceeds that of a pickup in inflation from its already low level." In early June, Greenspan told an Institute of International Finance conference in Berlin that the Fed needed to create a "firebreak" against deflation. Traders eagerly bought more Treasuries on the expectation that the bank would cut interest rates further and, once the federal funds rate fell to 75 basis points, resort to unconventional measures to combat deflation.

So in late June when the central bank reduced the fed funds rate only 25 basis points -- instead of the 50 points that the market had been counting on -- surprised traders concluded that the Fed was backing away from its aggressive antideflation stance. It mattered little to the market that in its accompanying explanation the bank repeated its earlier language warning about a potential unwelcome fall in inflation. To be sure, part of the Fed's waffling was because economic indicators were beginning to show growth picking up.

Caught off guard, nonetheless, traders and investors began dumping bonds, and the sell-off gained impetus in mid-July when Greenspan downplayed the deflation threat in his semiannual testimony to Congress. "Situations requiring special policy actions are most unlikely to arise," the Fed chairman said.

An orderly retreat became a rout. The bond market panic was exacerbated by mortgage-backed-security traders rushing to sell Treasuries and swaps that they had used to hedge their positions. "The hedgers created a snowball effect that pushed the market to temporary extremes," says Douglas Greenig, head of mortgage and agency bonds at RBS Greenwich Capital. July turned out to be the single worst month for the bond market in more than two decades. The Lehman Brothers aggregate bond index fell 3.3 percent, causing hundreds of billions in losses. Pimco's flagship Total Return Fund alone lost almost $3 billion of its $76 billion in assets.

In his postmortem, Bernanke emphasizes that he and other Fed officials made a point of noting that the possibility of having to use unconventional measures was remote. "Somehow or other the probability that deflation was going to occur or that the Fed was going to use nonstandard tools was a bit exaggerated through constant discussion of this issue, and that was the source of the misunderstanding," he says. "I guess we should have emphasized even more strongly than we did that this was a contingency measure, not necessarily something that we were about to implement."

Although some traders fault Bernanke for misleading the markets, most of their ire is directed at Greenspan. "I blame Alan Greenspan, not Ben Bernanke, for the rocket ride of June and July," says Pimco's McCulley, who manages his firm's short-term-trading desk. "To be sure, Bernanke talked about unconventional measures in November, but Greenspan spoke about buying out the curve before Bernanke did. Bernanke got too much criticism for doing his civic duty."

Greenspan in fact told Congress's joint economic committee in mid-November 2002 that if "we got to the point where we could no longer lower the target federal funds rate, we could nonetheless increase the liquidity of the system by moving out on the maturity schedule as far as we wanted." Bernanke says that his speech later that month merely sought to clarify the issue. "The press was saying that the Fed was out of bullets," he points out.

Many in the markets appreciate what Bernanke is attempting to do. "He is providing a framework that addresses deflationary expectations regardless of their source," says Tudor Investment Corp.'s managing director, Robert Dugger. "He's not alone in this effort, but Ben's discussions are more thorough and more public." Sums up Dugger, "I see the source of confusion in the markets rather than the Fed."

Ironically, the markets may have been confused by the very transparency that Bernanke is promoting. "Markets are not used to the Fed speaking in increasingly plain language," says chief economist Lou Crandall of Wrightson ICAP, a research firm based in Jersey City, New Jersey. "So when Greenspan talked about a firebreak, the market thought the Fed was expressing itself in otherwise constrained language and would want that phrase to stand out."

Another possible cause of befuddlement: The markets may have mistaken Bernanke's and other Fed officials' ruminations on unresolved policy issues as tip-offs that those policies were about to be implemented. "In the past, strategy options were not discussed in the abstract and were talked about opportunistically to signal policy changes," Crandall says. "The Street was taking comments about strategy and applying them to implementation."

In any event, the bond market fiasco has sharpened the debate about how the Fed conducts and communicates its policies. As Bernanke observed in July, "In a world in which inflation risks are no longer one-sided and short-term nominal interest rates are at historical lows, the success of monetary policy depends more on how well the central bank communicates its plans and objectives than any other single factor."

Yet the transparency debate is more polarized than ever. The market's misreading of the Fed has had two effects, says former Fed vice chairman Blinder: "The school of thought that says we shouldn't talk will say this proves it; others will say that we should speak more clearly." His own judgment is that "what happened is an arrow in the quiver for clarity."

The rise of mortgage-backed-securities hedging adds to the pressure on the Fed to make itself understood. "The mortgage-hedging aspect has become so huge that any kind of significant move that may be generated in the first instance by fundamentals is then exaggerated extensively by mortgage-hedging pressure," notes Bernanke. "It gives us extra incentive to avoid sharp changes in stance that would lead to these big moves in the first place, and it makes it harder for us to read what's going on in the market."

But too much transparency has pitfalls of its own. "The problem with transparency is that the Fed doesn't always agree on what to do -- there are 19 people on the board," says one bond trader. "Markets say, 'You misled us'; the Fed says, 'But you wanted transparency.'"

Bernanke intends to continue speaking out. "My objective is to be frank and earnest in a positive way, in the sense that I communicate what I mean but don't necessarily break the china," he says. In early September, when bond traders were puzzled by the Fed's vague pronouncement that it would maintain low interest rates for "a considerable period," Bernanke sought to clarify matters by explaining that the bank wouldn't have to tighten monetary policy as quickly as it had in past recoveries because it would be a while before excess manufacturing capacity could be put to work, causing disinflationary pressures to ease. He also said interest rates would have to be cut further if unemployment didn't fall. The bond markets responded with a small rally, and traders started betting that the Fed wouldn't tighten until next year.

Bernanke would like the Fed to use clearer language, release the minutes of board meetings more promptly and provide more guidance on the bank's thinking on major issues. To his credit, Greenspan has made the Fed much more communicative than it was historically. The bank now reveals its policy tilt, formally announces interest rate changes -- the Fed instituted such seemingly obvious disclosure only in the mid-1990s -- and releases the minutes of its interest rate deliberations following its meetings.

But how much further should the Fed tip its hand? Might being too forthcoming about monetary policy aims compromise the Fed's effectiveness in the markets? From this perspective, inflation-targeting -- Bernanke's other great cause -- boils down to a communications question.

"What I have in mind here is not a formal inflation target but rather a tool for aiding communication," he said in a July speech. "The main purpose . . . would be to provide some guidance to the public and to financial markets as they try to forecast FOMC behavior." Rather than urging adoption of a strict, rule-based monetary policy, Bernanke supports flexible inflation-targeting that would give the Fed the freedom to deviate from the announced inflation targets to deal with financial crises or other disruptive events.

The St. Louis Fed's Poole, who joined Bernanke this August in calling for the central bank to state its inflation target, argues that this summer's bond market imbroglio might have been avoided if traders had known in advance what the Fed's inflation targets were. Asserts Poole: "If five years ago, when inflation was in the 2.5 to 3.5 percent range, the FOMC had had a full discussion of these circumstances and said its long-term policy was to lower inflation to 1 percent of the personal consumption expenditures deflator, then the Fed's May statement wouldn't have been a surprise to the markets. This is an example of when inflation-targeting would have helped clarify Fed communications."

Bernanke maintains that announcing inflation targets would not only increase the Fed's transparency and accountability but also "symmetrically" focus it on guarding against inflation, on the one hand, and deflation, on the other. He is also well aware that apart from the theory's abstract merits, its timely introduction could help the Fed preserve its credibility after Greenspan retires. "The problem with Alan Greenspan's legacy is its nonreplicability: There's no clear blueprint," says Blinder. "Inflation-targeting is a post-Greenspan decision that will become a big debate."

Since 1990 more than 20 countries have adopted some form of inflation-targeting. They include industrialized countries like Canada, the U.K. and New Zealand (the first to adopt targets) as well as developing countries such as Brazil and Chile. All have dealt in different ways with inflation-targeting's vexing issues: Which inflation indexes do you select for targeting? How fast do you try to get back on target if you are forced to deviate in an emergency? How do you set up and then evaluate the system? The Australian central bank, for instance, adopted a dual mandate of promoting both economic growth and price stability. By contrast, the Bank of England's brief is price stability first and foremost.

Inflation-targeting brings modest net benefits, concludes a recent study by Institute of International Economics senior fellow and former Fed official Edwin Truman. "On balance, inflation-targeting is a good idea," he says. "The U.S. case is the weakest, because targeting only provides a little bit more transparency. In the EU it would help clarify the European Central Bank's message, and in Japan, where the case is the strongest, it doesn't solve the problem of deflation but could be an insurance policy."

Many Fed board members, including Greenspan, Ferguson and Kohn, are highly skeptical of inflation-targeting, however. They see it as less flexible than the current regime and, moreover, unnecessary. The Fed has credibility as an inflation-fighting institution, and it does view inflation symmetrically, they assert. "The quantified inflation target would come to take greater prominence over other important and consistent objectives implied by the flexible approach, with an inevitable reduction in flexibility and a downplaying of those other objectives," said Ferguson in a February speech. "Because responding to financial crises requires flexibility, policy cannot be tied too tightly to a rule."

Bernanke insists that he's not out to convert opponents of inflation-targeting but simply wants to explain how the system would really work, and foster a debate. "It is important to talk about what inflation-targeting means and convey, concretely, how it would affect the Fed's operations and strategy," he says.

Provoking discussion, of course, is the Fed governor's brief. "Ben Bernanke and Don Kohn disagree on some issues, but it is important that both points of view are heard and debated and openly discussed -- one issue is inflation-targeting, and it is important to have a variety of views expressed on that," says Council of Economic Advisers chief Mankiw.

And like the outstanding professor he once was, Bernanke conducts a good seminar. "Whatever one might say, the discussions we've had on a variety of issues have been advanced quite a bit," he says. "So I am very happy that even if my recommendations aren't always taken, they are always taken seriously -- that's really all I ask for." Though respected as a leading thinker on monetary policy, Bernanke lacks the political credentials and track record to become Fed chairman himself in the near future, most observers say. But at a time when the central bank has begun to grope for a post-Greenspan modus operandi, Bernanke's role is nonetheless critical. Says former Fed governor Meyer, "What Ben Bernanke is providing is vision."

Why Bernanke likes targeting

Going from professor to policymaker can be tougher than, say, going from actor to politician. But in little more than a year, former Princeton University scholar Ben Bernanke has settled in quite comfortably at the Federal Reserve Board -- too comfortably, his critics would say. Named to a 14-year term by President George W. Bush with a mandate to foment new thinking and generally stir things up, monetary policy expert Bernanke, 49, has prompted a lively and at times heated debate within and outside the Fed about its future. Should the bank disclose its inflation targets? Should it reveal more about its policy moves? Bernanke discussed these and other charged topics with Institutional Investor Senior Writer Deepak Gopinath.

Institutional Investor: You're a champion of inflation-targeting, but chairman Alan Greenspan is not.

Bernanke: We have some disagreement on inflation-targeting, but he has been more than willing to talk about it.

Why is there so much resistance to inflation-targeting?

There is still a great deal of misunderstanding. Some take the view that targeting would be a mechanical rule with no human judgment. That is simply wrong. Others take the view that inflation-targeting entails a maniacal attention to inflation but no attention to growth and employment, which is also wrong.

How do you correct this misunderstanding?

I think of this as the education phase. We need more deliberation and discussion. It is important to talk about what inflation-targeting involves and how, concretely, it would affect the Fed. Once that is done, then there are legitimate issues to consider, which I certainly am not dogmatic about.

Which issues might those be? For example, is it beneficial to define price stability quantitatively?

Some Federal Open Market Committee members think that price stability should be defined in a qualitative way -- as the inflation level at which households and firms do not take price rises into account when making decisions. An inflation-targeting central banker would say, 'No, we want to define price stability in terms of some price index to set a specific range for inflation.' There are legitimate issues as to whether that approach would limit flexibility, on the one hand, or, on the other, be more transparent and informative. Although I would like to have something like quantitative targeting, I am ready to be persuaded otherwise.

Would inflation-targeting make it more difficult for the Fed to respond to unusual events like financial crises?

Different institutions have different approaches to structuring inflation targets. The Fed -- which has achieved price stability -- has a lot of credibility and therefore could have a relatively loose inflation objective. We could provide information about where we think inflation ought to be in the medium term without rigid rules or time frames that would force us to behave in a mechanical way. So I could see implementing inflation-targeting in a flexible way that would not be at all inconsistent with chairman Greenspan's vision of risk management.

How so?

If you think of risk management as taking out insurance against unusual possibilities, that is sound policy, and I have no objection to that. That is not inconsistent with my vision of inflation-targeting, which visualizes providing information to the market about where inflation should be when the economy returns to a steady state.

Has the Fed achieved a secular victory over inflation? Are we in a disinflationary era?

The old relationships have not broken down. If monetary policy is eased sufficiently, inflation will come right back. Vigilance is always needed. Part of my whole philosophy of inflation-targeting is that building up credibility for low and stable inflation is a crucial part of monetary policy and a valuable asset to be safeguarded. It is at times like this when it becomes so valuable, because in the past couple of years, the Fed has been able to ease monetary policy drastically to support the economy yet generate almost no inflation expectations. We were able to do that because over the years we built up tremendous credibility. Maintaining that credibility is more important than ever.

What lessons do you draw from this summer's bond market turmoil?

The most important is for the Fed to be clear and consistent. To a large extent we were, but I guess we should have emphasized even more strongly that we were studying nonstandard monetary policy tools only as a contingency measure, not as something we were necessarily about to implement. That may have been a unique occurrence. Inflation-targeting addresses the situation where people are trying to figure out whether and when the Fed will tighten or ease. Knowing something about the Fed's long-run objectives provides information about how much price pressure up or down we'll tolerate before we take action.

Some say that the market was caught off guard because the Fed spoke in more direct language than investors were used to.

That might be part of the problem. Certainly, we are in a new environment. The Fed is not fighting just inflation. It is also trying to adapt to symmetric risks -- both upside risks in higher inflation and downside risks in disinflation or deflation. That makes our actions more ambiguous and harder to communicate to the market.

The Fed's board decided at a special meeting in September not to make any immediate changes in the way it communicates. Do you support that decision?

My view is that we should be more explicit about our objectives, so I would like to see us provide more information about where we think inflation will be once the economy picks up. I would also like to see us provide longer-horizon and more regular economic forecasts. I would be in favor of moving up the release date of the minutes from Federal Open Market Committee meetings and thus getting out more timely information about the Fed's deliberations. That would provide much more forward-looking information and reduce the burden on the statement that follows FOMC meetings.

The Fed said that it intends to maintain low interest rates for a "considerable period." How long is that?

The Fed does not have to tighten monetary policy as quickly as it has in the past in response to faster GDP growth. This is for two reasons. One is that inflation starts at a low level -- a level that may be too low for some of us -- and, secondly, that we have such productivity growth that strong output numbers don't necessarily translate into tightening labor and input markets. So we have the paradox of very rapid GDP growth and very slow declines in unemployment rates, very weak price and wage pressures and hence very low inflation pressure. There could very well be a considerable lag before excess capacity begins to be eaten up and we begin to see inflationary pressures. I can't tell you how many months that will be.

Are you comfortable with being known as the most plainspoken Fed governor?

That can be a compliment, or it can be the reverse. If it means that I'm basically honest and try to communicate what I think and try to be frank and straightforward with the markets, then I appreciate that. If it means I am a bull in a china shop, then obviously I don't want to be that.