Tag: Inflation Target

Watching as the Federal Reserve juggles priceless eggs in variable gravity…

Posted on by Brad DeLong

Is it necessary to say that we hold Ben Bernanke, Mervyn King, Mark Carney, Janet Yellen, Stan Fischer, Lael Brainard, and company to the highest of high standards–demand from them constant triple aerial somersaults on the trapeze–because we have the greatest respect for and confidence in them? It probably is…

Back in 1992 Larry Summers and I wrote that pushing the target inflation rate from 5% down to 2% was a very dubious and hazardous enterprise because the zero-lower bound was potentially a big deal: “The relaxation of monetary policy seen over the past three years in the United States would have been arithmetically impossible had inflation and nominal interest rates both been three percentage points lower in 1989. Thus a more vigorous policy of reducing inflation to zero in the mid-1980s might have led to a recent recession much more severe than we have in fact seen…”

This does seem, in retrospect, to have been quite possibly the smartest and most foresightful thing I have ever written. Future historians will, I think, have a very difficult time explaining how the cult of 2%/year inflation targeting got itself established in the 1990s. And they will, I think, have an even harder time explaining why the first monetary policymaker reaction to 2008-2012 was not to endorse Olivier Blanchard et al.’s call for a higher, 4%/year, inflation target in the coded terms of IMF speak:

The great moderation (Gali and Gambetti 2009) lulled macroeconomists and policymakers alike in the belief that we knew how to conduct macroeconomic policy. The crisis clearly forces us to question that assessment….

The crisis has shown that large adverse shocks do happen. Should policymakers aim for a higher target inflation rate in normal times, in order to increase the room for monetary policy to react to such shocks? Are the net costs of inflation much higher at, say, 4% than at 2%, the current target range? Is it more difficult to anchor expectations at 4% than at 2%? Achieving low inflation through central bank independence has been a historic accomplishment. Thus, answering these questions implies carefully revisiting the benefits and costs of inflation.

A related question is whether, when the inflation rate becomes very low, policymakers should err on the side of a more lax monetary policy, so as to minimize the likelihood of deflation, even if this means incurring the risk of higher inflation in the event of an unexpectedly strong pickup in demand. This issue, which was on the mind of the Fed in the early 2000s, is one we must return to…

But instead we got a very different reaction. Sudeep Reddy reported on it back in 2009:

Sudeep Reddy (2009): Sen. Vitter Presents End-of-Term Exam For Bernanke: “Earlier this month, Real Time Economics presented questions from several economists…

…for the confirmation hearing of Federal Reserve Chairman Ben Bernanke…. Sen. David Vitter (R., La.) submitted them in writing and received the responses from Bernanke….

D. Brad Delong, University of California at Berkeley and blogger: Why haven’t you adopted a 3% per year inflation target?

[Bernanke:] The public’s understanding of the Federal Reserve’s commitment to price stability helps to anchor inflation expectations and enhances the effectiveness of monetary policy, thereby contributing to stability in both prices and economic activity. Indeed, the longer-run inflation expectations of households and businesses have remained very stable over recent years. The Federal Reserve has not followed the suggestion of some that it pursue a monetary policy strategy aimed at pushing up longer-run inflation expectations.

In theory, such an approach could reduce real interest rates and so stimulate spending and output. However, that theoretical argument ignores the risk that such a policy could cause the public to lose confidence in the central bank’s willingness to resist further upward shifts in inflation, and so undermine the effectiveness of monetary policy going forward.

The anchoring of inflation expectations is a hard-won success that has been achieved over the course of three decades, and this stability cannot be taken for granted. Therefore, the Federal Reserve’s policy actions as well as its communications have been aimed at keeping inflation expectations firmly anchored.

This sounds like nothing so much as the explanations offered in the 1920s and 1930s for returning to and sticking with the gold standard at pre-WWI parities, and the explanations offered at the start of the 1990s by British Tories for sticking to the fixed parities of the then-Exchange Rate Mechanism. The short answer is that real useful positive credibility is not built by attempts to stick to policies that are in the long run destructive–and hence both incredible and stupid. As we learn more about the economy and as the structure of the economy changes, the optimal long-run policy strategy changes as well. Credibility arising from a commitment that the Federal Reserve will seek to follow an optimal long-run policy framework and to accurately convey its intentions but will revise that framework in light of knowledge and events is worth gaining and maintaining. Credibility arising from a commitment to stick, come hell or high water, to a number that Alan Greenspan essentially pulled out of the air with next to no substantive analytical backing in terms of optimal-control analysis is not.

Now, however, we have another answer from Janet Yellen: that the zero lower bound is not, in fact, such a big deal:

Janet Yellen: The Outlook, Uncertainty, and Monetary Policy: “One must be careful, however, not to overstate the asymmetries affecting monetary policy at the moment…

…Even if the federal funds rate were to return to near zero, the FOMC would still have considerable scope to provide additional accommodation. In particular, we could use the approaches that we and other central banks successfully employed in the wake of the financial crisis to put additional downward pressure on long-term interest rates and so support the economy–specifically, forward guidance about the future path of the federal funds rate and increases in the size or duration of our holdings of long-term securities.10 While these tools may entail some risks and costs that do not apply to the federal funds rate, we used them effectively to strengthen the recovery from the Great Recession, and we would do so again if needed.

Over on the Twitter Machine, the very-sharp Tim Duy–I take it from his picture that there is ample snowpack for the ski resorts in the Cascade Range–is impressed by how different the tone of this speech is with the get-ready-for-liftoff speeches of last fall:

And Dario Perkins and Mark Grady have chimed in in support: “suddenly she’s realised the rest of the world matters!…” and “lots of common messages, but emphasis v[ery] diff[erent] on the risks. And no mention of lags or falling behind the curve at all…”

I, by contrast, am still struck by the gap that remains between where she seems to be and where I am.

For there is a natural next set of questions to ask anyone who says that the zero lower bound and the liquidity trap are not big deals. That set is:

  • Then why isn’t nominal GDP on its pre-2008 trend growth path?

  • Why is the five-year ahead five-year market inflation outlook so pessimistic?

  • Why hasn’t the Federal Reserve pushed interest rates low enough so that investment as a whole counterbalances the collapse in government purchases we have seen since 2010?

Gross Domestic Product FRED St Louis Fed Graph 5 Year 5 Year Forward Inflation Expectation Rate FRED St Louis Fed FRED Graph FRED St Louis Fed

I cannot help but be struck by the difference between what I see as the attitude of the current Federal Reserve, anxious not to do anything to endanger its “credibility”, and the Greenspan Fed of the late 1990s, which assumed that it had credibility and that because it had credibility it was free to experiment with policies that seemed likely to be optimal in the moment precisely because markets understood its long-term objective function and trusted it, and hence would not take short-run policy moves as indicative of long-run policy instability. There is a sense in which credibility is like a gold reserve: It is there to be drawn on and used in emergencies. The gold standard collapsed into the Great Depression in the 1930s in large part because both the Bank of France and the Federal Reserve believed that their gold reserves should never decline, but always either stay stable of increase.

It was Mark Twain who said that although history does not repeat itself, it does rhyme. The extent to which this is true was brought home to me recently by Barry Eichengreen’s excellent Hall of Mirrors…

I tell you, I have a brand new set of lectures to write for a large monetary-policy module in American Economic History…

Marginal Notes on Janet Yellen’s Footnote 14

Posted on by Brad DeLong

The answer to the last point Janet Yellen makes in her famous Footnote 14 is:

  • If is indeed the case that targeting an inflation rate of 4%/year “stretch[es] the meaning of ‘stable prices’ in the Federal Reserve Act”, then targeting an inflation rate of 2%/year does not stretch the meaning of but rather eliminates the “maximum employment” objective in the Federal Reserve Act. Congress has left the Federal Reserve freedom to deal as best as it can with an imperfect world in which all of the statutory objectives cannot be achieved perfectly. It is the Fed’s choice how to balance.

The answers to her other points are:

  • If it is indeed that case that “changing the FOMC’s long-run inflation objective would risk calling into question the FOMC’s commitment to stabilizing inflation at any level…” failing to change does not risk but does call into question the FOMC’s commitment to maximum employment and to financial stability as well.

  • If it is indeed that case that “it is not obvious that a modestly higher target rate of inflation would have greatly increased the Federal Reserve’s ability to support real activity…” it is still the case that a higher inflation target allows the Federal Reserve to achieve the same degree of monetary ease measured in terms of real interest rates without putting nearly as much adverse and unfortunate pressure on the commercial banking system’s finances. A Federal Reserve that seeks–as it should–to both use monetary policy to support increased real activity as well as avoid putting undue destructive pressure on the commercial banking sector should welcome the additional sea room provided by a higher inflation target, even if the benefits from lower real interest rates in terms of supporting real activity are only modest.

  • If it is indeed the case that the Federal Reserve is confident that it can “use large-scale asset purchases and other unconventional tools to mitigate the costs arising from the ELB constraint…” the Federal Reserve is unique in being the only organization of economists that possesses such confidence.

  • And, last, it is indeed the case that the “earlier analyses of ELB costs” that underpinned the decision to adopt 2%/year as an inflation target “significantly underestimated the likelihood of severe recessions and slow recoveries of the sort recently experienced…” A policy choice substantially based on the wrong assumptions is highly likely to be exchanged at some point for one based on the right assumptions. And the sooner the shift is made, the better–both in terms of avoiding the costs of having bad policy, and avoiding the costs of uncertainty and lack of credibility generated by claiming a credible commitment to permanently pursue a not-very-credible policy.

Janet Yellen: Footnote 14: “Blanchard, Dell’Ariccia and Mauro (2010), among others…

…have recently suggested that central banks should consider raising their inflation targets, on the grounds that conditions since the financial crisis have demonstrated that monetary policy is more constrained by the effective lower bound (ELB) on nominal interest rates than was originally estimated. Ball (2013), for example, has proposed 4 percent as a more appropriate target for the FOMC. While it is certainly true that earlier analyses of ELB costs significantly underestimated the likelihood of severe recessions and slow recoveries of the sort recently experienced in the United States and elsewhere (see Chung and others, 2012), it is also the case that these analyses did not take into account central banks’ ability to use large-scale asset purchases and other unconventional tools to mitigate the costs arising from the ELB constraint.

In addition, it is not obvious that a modestly higher target rate of inflation would have greatly increased the Federal Reserve’s ability to support real activity in the special conditions that prevailed in the wake of the financial crisis, when some of the channels through which lower interest rates stimulate aggregate spending, such as housing construction, were probably attenuated. Beyond these tactical considerations, however, changing the FOMC’s long-run inflation objective would risk calling into question the FOMC’s commitment to stabilizing inflation at any level because it might lead people to suspect that the target could be changed opportunistically in the future. If so, then the key benefits of stable inflation expectations discussed below–an increased ability of monetary policy to fight economic downturns without sacrificing price stability–might be lost.

Moreover, if the purpose of a higher inflation target is to increase the ability of central banks to deal with the severe recessions that follow financial crises, then a better strategic approach might be to rely on more vigorous supervisory and macroprudential policies to reduce the likelihood of such events. Finally, targeting inflation in the vicinity of 4 percent or higher would stretch the meaning of ‘stable prices’ in the Federal Reserve Act…