Must-read: Narayana Kocherlakota: “The Fed’s Credibility Dilemma”

Must-Read: Narayana Kocherlakota: The Fed’s Credibility Dilemma: “What will happen if inflationary pressures prove stronger than expected…

…over the next year or so. In principle, the Fed can curb inflation by raising its interest-rate target sufficiently rapidly. In practice… it must break either its commitment to move gradually, or to keep inflation close to 2 percent… [and] will lose credibility. Worse, suppose that economic growth turns out to be weaker…. Again… communication becomes an obstacle: By expressing its strong preference for normalization, the Fed has been telling investors that they can safely ignore the possibility of a reduction in rates (at the end of her March 16 press conference, for example, Chair Janet Yellen stressed that officials are not even discussing the possibility of adding stimulus). So to respond appropriately… the Fed would have to renege….

Ironically, the Fed’s perceived commitment not to cut interest rates could actually make it reluctant to raise them…. To maintain flexibility… they might choose not to raise rates in the first place. That way they’ll run a smaller risk of being forced to go back on their normalization commitment. So what, if any, plans should the Fed communicate?… They should be much clearer about their willingness to make large and rapid changes in monetary policy… stress that they are ready to do ‘whatever it takes’ to keep employment up and inflation near target…