Tag: Inflation Expectations Imp

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

Posted on by Brad DeLong

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…

Must-Read: Gauti Eggertson and Michael Woodford: The Zero Bound on Interest Rates and Optimal Monetary Policy

Posted on by Brad DeLong

Must-Read: The reality-based piece of the macroeconomic world is right now divided between those who think (1) that Bernanke shot himself in the foot and robbed himself of all traction by refusing to embrace monetary régime change and a higher inflation target, and thus neutered his own quantitative-easing policy; and (2) that at least under current conditions markets need to be shown the money in the form of higher spending right now before they will give any credit to factors that make suggest they should raise their expectation of future inflation. What pieces of information could we seek out that would help us decide whether (1) or (2) is correct?

Gauti Eggertson and Michael Woodford (2003): The Zero Bound on Interest Rates and Optimal Monetary Policy: “Our dynamic analysis also allows us to further clarify the several ways…

…in which the central bank’s management of private sector expectations can be expected to mitigate the effects of the zero bound. Krugman emphasizes the fact that increased expectations of inflation can lower the real interest rate implied by a zero nominal interest rate. This might suggest, however, that the central bank can affect the economy only insofar as it affects expectations regarding a variable that it cannot influence except quite indirectly; it might also suggest that the only expectations that should matter are those regarding inflation over the relatively short horizon corresponding to the term of the nominal interest rate that has fallen to zero. Such interpretations easily lead to skepticism about the practical effectiveness of the expectations channel, especially if inflation is regarded as being relatively “sticky” in the short run.

Our model is instead one in which expectations affect aggregate demand through several channels…. Inflation expectations, even… [more than] a year into the future… [are] highly relevant… the expected future path of nominal interest rates matters, and not just their current level… any failure of… credib[ility] will not be due to skepticism about whether the central bank is able to follow through on its commitment…