Managing Disinflation

Large, advanced economy central banks are working hard to lower inflation from 40-year highs. Policy rates are up sharply in Canada, the euro area, the United Kingdom and the United States. While disinflation has started, inflation remains far above policymakers’ common target of 2 percent.

Based on their latest projections published in December, most U.S. Federal Open Market Committee (FOMC) participants anticipate a largely benign return to price stability, without a decline in real GDP or a rise of the unemployment rate to much more than 4½ percent. Is this optimism justified? Pointing to the historical record, some prominent analysts wonder whether it is possible to engineer such a large disinflation at what would be such a low cost (see, for example, Lawrence Summers).

This is the setting for this year’s report for the U.S. Monetary Policy Forum that we wrote with Michael Feroli, Peter Hooper and Frederic Mishkin. In the report, we focus on the central challenge facing central banks today: how to minimize the costs of disinflation. To address this question, we employ two approaches: a historical analysis in which we assess the costs of sizable disinflations since the 1950s; and a model-based analysis in which we examine the degree to which policymakers might have been able to anticipate the recent surge of inflation, as well as the path of policy that is likely needed to achieve the desired disinflation.

In the remainder of this post, we summarize the USMPF report’s analysis and conclusions….

The Slippery Slope of a Higher Inflation Target

With inflation significantly above target in most advanced economies, there are renewed calls for central banks to raise their targets from 2% to 3% or 4%, in order to limit the prospective costs of disinflation. In this post, we review the benefits and costs of a higher inflation target.

Yet, regardless of the balance between the costs and benefits of raising the inflation target, our view is that central banks ought not be able to choose their inflation targets. The key problem with such discretion is the slippery slope. If households and firms come to expect that a central bank will opportunistically raise its inflation target to avoid the economic sacrifice associated with disinflation, inflation expectations will no longer be anchored at the target (whatever it is).

To limit the “inflation expectations ratchet”—avoiding perceptions of opportunistic central bank discretion— the Federal Reserve should follow an approach that it now employs regarding the possible introduction of a central bank digital currency: namely, the Fed should announce that it will not alter its inflation target without the explicit support of both the legislative and executive branches, ideally in the form of legislation….

The Price is Not Right: Measuring Inflation in a Pandemic

Are prices really plummeting? If you watch the official government gauge of prices in the economy, you would think so. Between March and April, the Consumer Price Index (CPI) dropped by 0.8 percent―that’s a decline of 9.1 percent at an annual rate! Even if we exclude food and energy, prices still fell at half that rate. And, both price measures already had begun to fall the previous month. Is this the new trend? Are we in the midst of a deflation? The short answer is no.

The pandemic is an enormous shock to both supply and demand (see our earlier post). The productive capacity of the economy is lower both now (with the lockdown) and in the medium term (with the need to make economic activity biologically safer). Similarly, demand is lower both temporarily while people stay at home and in the longer term as the propensity to save rises to enable people to pay off elevated debts and build precautionary buffers. Determining which of these shifts prevails is essential for policymakers. If the demand contraction dominates, then trend inflation will fall and policymakers will need to implement further expansionary policies. Conversely, if trend inflation rises (implying that the supply constraints prevail), then policymakers will eventually need to introduce restraint.

In this post, we discuss the difficulties of measuring inflation during a pandemic—when demand and supply both shift dramatically. Our conclusion is that some indices provide better high-frequency signals of the trend. Unsurprisingly, headline measures of inflation are especially poor. Yet, traditional measures of “core inflation” that exclude food and energy may be equally bad. Instead, we suggest focusing on the “trimmed mean,” a statistical construct that disregards all goods and services whose prices change by the largest amounts (either up or down). In recent months, the trimmed mean CPI shows suggest that inflation has edged lower, but remains between 1½ and 2 percent per year….

Navigating in Cloudy Skies

Stargazers hate clouds. Even modest levels of humidity and wind make it hard to “see” the wonders of the night sky. Very few places on our planet have consistently clear, dark skies.

Central bankers face a similar, albeit earthly, challenge. Even the simplest economic models require estimation of unobservable factors; something that generates considerable uncertainty. As Vice Chairman Clarida recently explained, the Fed depends on new data not only to assess the current state of the U.S. economy, but also to pin down the factors that drive a wide range of models that guide policymakers’ decisions.

In this post, we highlight how the Federal Open Market Committee’s (FOMC’s) views of two of those “starry” guides—the natural rates of interest (r*) and unemployment (u*)—have evolved in recent years. Like sailors under a cloudy sky, central bankers may need to shift course when the clouds part, revealing that they incorrectly estimated these economic stars. The uncertainty resulting from unavoidable imprecision not only affects policy setting, but also complicates policymakers’ communication, which is one of the keys to making policy effective….

The Fed's Price Stability Achievement

Over the past decade, critics of all stripes have assailed Federal Reserve monetary policy. At one end of the spectrum, some argued that the Fed’s expansionary balance sheet policy risked currency debasement and high inflation. While some of these critics sought merely to influence ongoing policy, others called for replacing the Fed altogether, and restoring the Gold Standard. And then there were those promoting oversight over monetary policy operations that would significantly curtail central bank independence.

At the other end, a different set of critics worried about outright deflation: according to monthly averages from Google Trends, since 2004, U.S. searches for deflation were twice as frequent as those for hyperinflation. Some economists called for a higher inflation target. Squarely in the second camp, officials inside the Federal Reserve System developed deflation probability trackers like this one (here is another from the Federal Reserve Bank of Atlanta).

These diverse perspectives form the backdrop to this year's report for the U.S Monetary Policy Forum (USMPF) that we co-authored with Michael Feroli, Peter Hooper and Anil Kashyap. In that paper, we document that the trend in U.S. inflation has been remarkably low and stable since the early 1990s....

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