What we talk about when we talk about doves
Dove used to be a pejorative in central banking. Bob McTeer, a Dallas Fed president, once cracked that “Only hawks go to central banker heaven.” There were, in fact, sound theoretical reasons for a hawkish predisposition. A president may claim to want low inflation but prefer the central bank focus on unemployment, at least until after the next election. Some other president could deal with the resulting inflation. Because the public knows this, it is predisposed to expect higher inflation and demand higher interest rates no matter what the president and his Fed chairman say. This was called the “time inconsistency” problem. In an early 1980s paper Ken Rogoff argued that presidents can short-circuit this process by appointing someone more hawkish than they are, establishing useful credibility up front that helps contain both inflation and interest rates. An inflation target was also originally meant to address the time inconsistency problem. Yet as Mr Hooper notes, it also renders the terms hawk and dove meaningless in an absolute sense. Properly applied it would require any central banker to bring inflation back to target from above or below. Ms Yellen’s advocacy in 1996 of a 2% target was dovish relative to her colleagues who at the time wanted zero, but when inflation threatened to poke above 2%, it forced her to turn hawkish.
Today, however, lack of inflation credibility is not the Fed’s problem. As the article notes, the world since 2008 is one marked by slack demand, high unemployment, and inflation that has persistently fallen short of target. As Christina Romer says, “Over the last five years people seem to be fighting the last war. They were so afraid of repeating the 1970s, they were risking repeating the 1930s.” In that environment, the Fed needs someone like Ms Yellen who realizes the world has changed. She has been dovish, because she rightly perceived earlier than most that inflation was more likely to undershoot and unemployment to persist at dangerously high levels.
A 2% target does not simply mean keeping inflation from topping 2%; it means ensuring that the forecast range for inflation centers on 2%. Distressingly, the range of Fed inflation forecasts persistently fall short, which suggests the Fed itself realizes its policy is too tight relative to optimum inflation.
I would go even further. Adherence to a flexible 2% target should mean more than defending it from below: it means tolerating overshoots if unemployment is unacceptably high. This could in practice, yield a range of inflation forecasts that center, temporarily, above 2%. This may sound inconsistent with a 2% target, but in fact is completely consistent when interest rates are stuck at zero. In such a situation it is easier to correct an inflation overshoot by raising rates a lot later, than it is to correct an undershoot by cutting rates. The latter error could produce a prolonged period of deficient demand (actually, it already has). The probability of a temporary overshoot may be higher; but the cost of an undershoot is greater. Weighted by probability and cost, a symmetric 2% inflation target requires a bias in favor of higher inflation. While some of Ms Yellen’s speeches last year seem open to this view, I predict, like Mr Hooper, that she will react relatively conventionally to upside risks on inflation.
In any case, Ms Yellen’s greater concern for unemployment than inflation does not make her an outlier. Most Fed officials feel the same way and if rates were, say, 3% today, most would happily chop them to 1% to hasten the drop in unemployment. The Fed’s hawks worry less that an ever expanding balance sheet will produce inflation than that it distorts markets and breeds excesses that are difficult to unwind later. Some also doubt that it really is helping boost demand now. Ms Yellen agrees there are costs but simply believes that they are still less than the benefits. This may make her a dove. But if the circumstances change, she will change her mind, and her feathers.
The original post is linked here.