Greg Ip

Articles by The Economist’s U.S. Economics Editor

The Federal Reserve’s inflation target: Shiny, new, unopened & unused

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Jun 18th 2012, 16:35 by G.I. | WASHINGTON

When Federal Reserve officials meet this week, they will despondently confront an economy yet again falling short. Employment growth has flagged. GDP probably grew less than 2% (annualized) in the first half of this year; clouds from Europe, Asia and America’s own “fiscal cliff” darken the second half. The Federal Open Market Committee’s full year forecast of 2.4% to 2.9% looks out of reach.

So what will they do? Much of the street expects some kind of action, a view I share. It would probably come as an extension of “Operation Twist,” the purchase of longer-term bonds in exchange for short or medium bonds already in the Fed’s portfolio. It could stretch this out over a few months or a full year.

This, however, will be fiddling at the edges. What critics say the Fed needs is a wholesale makeover of its goals and methods. Some want the Fed to raise its inflation target. Others would have it adopt a nominal GDP target. Both approaches are intended to induce easier monetary policy that would foster faster growth in employment.  At the opposite end of the spectrum, more conservative economists and Republican legislators want to take away the Fed’s responsibility for full employment and have it focus solely on inflation.

Lost in this blizzard of outside advice is the fact that the Fed actually has a new framework of its own. In January it declared that henceforth its long-run target for inflation was 2%. Previously Fed members only stated their long-run preference, which ranged from 1.5% to 2%. It also said it considered its two statutory goals, low inflation and full employment, equally important. Previously, employment was, de facto, subordinate to inflation.

If you haven’t heard more about this, it’s because the Fed has treated the target like an unwanted Christmas gift, still unopened months after the tree has been taken down. The initial announcement was devoid of any hint of radicalism; it didn’t even use the word “target” or spell out the implications of its “balanced” approach to inflation and employment. It felt like the FOMC couldn’t agree on whether it was, or ought to be, a genuine departure. Indeed, the Fed acts as if nothing has changed. Its “appropriate” monetary policy in April yielded  forecast inflation of 2% or lower over the next few years. This vindicates critics who say the Fed acts as if 2% is a ceiling, not a target.

If the Fed were conducting policy based on this new framework, inflation would be centered around 2%. Indeed, if the Fed treated employment and inflation equally, it would likely tolerate inflation above 2% given that it is missing its full employment mandate more than its low inflation mandate. 

What would such a policy look like? Fortunately, we don’t have to speculate. Janet Yellen, the Fed’s vice-chairman, described one in detail in speeches in April and in June. Ms Yellen uses a fairly conventional monetary policy rule in which the Fed seeks to minimize variations in inflation around its 2% target and in unemployment around its natural rate of 5.5%. In her simulation the Fed, by putting equal weight on its employment and inflation objectives, eases monetary policy more aggressively, keeping the federal funds rate at zero through the end of 2015 (instead of 2014 as currently projected). The result is a much more rapid decline in unemployment. Inflation briefly tops 2%, before returning to 2% over the long term.

This is important because the principle bone of contention between Ben Bernanke , the Fed chairman, and critics like Paul Krugman is over the value of keeping inflation expectations around 2%. Mr Bernanke believes the stability of actual and expected inflation around 2% has been hugely beneficial to society and enhanced the Fed’s operational flexibility. Writing off that investment, he has said, would be reckless. Mr Krugman believes those benefits are vastly outweighed by the good that comes from a higher inflation target, namely that it reduces real interest rates when nominal interest rates are stuck at zero.

The theory behind Mr Krugman’s point is not controversial. The Fed’s concern is that it will not work as well in practice. People don’t like inflation and may react adversely if told it is now a deliberate goal of the Fed. For example, because consumers suffer from money illusion, they may expect higher prices but not higher wages. The expectation of lower real income could reduce consumption.

The key insight of Ms Yellen’s approach is that it permits the more aggressive monetary policy that Mr Krugman and his ilk want without sacrificing the inflation target. Indeed, the target is crucial to the result. By pushing so hard on employment, the Fed generates transitory pressure on resources, a declining exchange rate, and some pass-through to commodities that together nudge inflation over 2%. But it doesn’t stay there because stable expectations drag it back to the 2% target. If, instead, inflation kept going higher, it would impose a variety of costs that negate the benefit of faster falling unemployment.

If anything, Ms Yellen’s model understates the case for more aggressive easing. That’s because it assumes overshoots and undershoots on the Fed’s objectives are equally bad. But that defies common sense. Temporarily undershooting on unemployment is much less costly to society than overshooting on it. A model that incorporated that asymmetry would prescribe even more aggressive support for employment.

Ms Yellen isn’t the first at the Fed to suggest something like this; Charlie Evans, the Chicago Fed president, has his own version: commit to getting unemployment below 7% provided inflation does not exceed 3%. Unlike Mr Evans, Ms Yellen is part of the Fed’s inner circle and has considerable input into Mr Bernanke’s decision. Which raises a question: if Ms Yellen has a plan that uses the Fed’s new framework to reduce unemployment more rapidly, why hasn’t the Fed adopted it?

There may be misgivings over the practicality of Ms Yellen’s approach, or internal resistance from other Fed members. Recall that as of April, Mr Bernanke was more dovishthan almost everyone else on the FOMC; Ms Yellen and Mr Evans are rare exceptions. Mr Bernanke may struggle to get a majority of the FOMC to swallow an even more aggressive path than the one already laid out. It’s also possible that Mr Bernanke already intends to pursue a monetary policy similar to what Ms Yellen has described, but this cannot be detected since his views are buried in the FOMC consensus.

Or perhaps it’s just a matter of time. The Fed’s new framework is only five months old. That’s about as long as it should take to get the wrapping off, insert the batteries, and switch on the motor.

The original post is linked here.


Written by gregip

June 18, 2012 at 6:51 am

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