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….

To improve Fed policy, improve communications

Since May 2021, we have criticized the Federal Reserve’s lagging response to surging inflation. In our view, both policy and communications were inadequate to address the looming challenge. Early this year, we argued that the Fed created a policy crisis by refusing to acknowledge the rise of trend inflation, maintaining a hyper-expansionary policy well after trend inflation reached levels far above their 2% target, and failing to articulate a credible low-inflation policy.

Against this background, we commend the FOMC for its recent efforts. Not only is policy moving quickly in the right direction, but communication improved markedly. In particular, despite the increasing likelihood of a near-term recession, Chair Powell made clear that price stability is necessary for achieving the second part of the Fed’s dual mandate. We suspect that the combination of the Fed’s recent promise to make policy restrictive, along with its improved communications, is playing a key role in anchoring longer-term inflation expectations.

In this post, we focus on central bank communication and its link to policy setting. By far the most important goal of communication is to clarify the authorities’ reaction function: the systematic response of central bank policy to prospective changes in key economy-wide fundamentals—usually inflation and the unemployment rate.

To anticipate our conclusions, we argue for two changes to the FOMC’s quarterly Summary of Economic Projections to better illuminate the Committee reaction function. First, we encourage publication of more detail on individual participants’ responses to link individual projections of inflation, economic growth, and unemployment to the path of the policy rate. Second, we see a role for scenario analysis in which FOMC participants provide their anticipated policy path contingent on one or more adverse supply shocks that present unappealing policy tradeoffs (for example, between the speed of returning inflation to its target and the pace at which the unemployment rate returns to its sustainable level)….

Trend inflation: How wages and housing are sustaining momentum

While annual inflation may have peaked, it remains at levels we last saw in the early 1980s. Indeed, our preferred measure of the medium-term inflation trend– the six-month annualized change in the trimmed mean personal consumption expenditure price index—is up by nearly 5 percent. Fortunately, policymakers now realize the severity of the situation and are raising interest rates quickly as they work to catch up. Fed fund futures anticipate a rate of at least 3½ percent by yearend—the most rapid increase in more than 40 years. Will this be enough?

In this post, we address this question. Our conclusion is that policymakers will have to act more aggressively than financial markets anticipate if inflation is to decline to the Fed’s 2-percent target within two years. The reason is that inflation has substantial forward momentum arising from two sources. First, a tight labor market combined with elevated short-term inflation expectations appear poised to drive wage inflation higher. Second, there is the continuing impact of increases in prices of housing, both for owners and renters. So, while energy prices as well as other temporary drivers of the current high inflation are fading, and long-term inflation expectations remain reasonably contained, inflation is currently poised to remain well above 2 percent….

The Costs of Acting Too Little, Too Late

Central bankers that act too little too late risk inflation, recession, or both. Everyone, including the members of the Federal Open Market Committee, knows that the FOMC is late in its current campaign to restore price stability. This makes it essential that they do not do too little.

In this post, we highlight the continued gap between the lessons of past disinflations and the Fed’s hopes and aspirations. We find it difficult to square the FOMC’s latest projections of falling inflation with only modest policy restraint. Simply put, we doubt that the peak projected policy rate from the June Summary of Economic Projections (SEP) will be sufficient to lower inflation to 2% in the absence of a recession.

In our view, boosting the credibility of the FOMC’s price stability commitment will require not only greater realism, but a clarification of how policy would evolve if, as in past large disinflations, the unemployment rate rises by several percentage points. The overly sanguine June SEP simply does not address this key question. Indeed, no FOMC participant anticipates the unemployment rate to rise above 4½% over the forecast horizon….

Harry Potter's Monetary Policy Wand?

The Federal Open Market Committee (FOMC) is reassuring us that, so long as we are patient, price stability will return without further pain. But its narrative seems less grounded in historical experience and more like something Harry Potter might have conjured at Hogwarts. By the end of 2024, the Committee expects trend inflation (measured by the price index of personal consumption expenditures excluding food and energy) to drop by more than 3 percentage points while economic growth remains above (and the unemployment rate below) its sustainable level. And, all this magic materializes with the real (inflation-adjusted) policy rate barely turning positive.

The principal means by which the Fed affects the inflation outlook is by influencing financial conditions. Yet, having telegraphed its policy shift for months, the FOMC’s most recent actions on March 16—initiating a series of rate hikes and suggesting that balance sheet tapering could begin soon—barely affected the ease with which firms and households obtain financing. And, while financial conditions are indeed a bit tighter than six months ago—when about one-half of FOMC participants anticipated no interest rate hikes in 2022—these conditions remain quite accommodative (see here).

Is the FOMC’s current policy path consistent with its longer-term price stability goals? In this post, we address this question by exploring policymakers’ newly published projections. Our conclusion is that bringing the inflation trend back to 2% will require a tightening of financial conditions significantly beyond what the Fed currently envisions….

Comments on Fed CBDC Paper

Last month, the Federal Reserve issued a long-awaited discussion paper on the possibility of introducing a central bank digital currency (CBDC) for retail use. The Fed paper calls for comments on the benefits and risk of introducing a U.S. CBDC, as well as on its optimal design. In this post, we respond to each of the 22 questions posed in the discussion paper. For the most part, these responses are based on our previous analyses of CBDC (here and here).

At the outset, we highlight our doubt that the benefits of a U.S. CBDC will exceed the risks. In our view, other, less risky, means are available to achieve all the key benefits that CBDC advocates anticipate. Moreover, we are not aware of sustainable design features that would reduce the risks of financial instability that many analysts agree will accompany the introduction of a digital U.S. dollar.

However, this overall judgment regarding a CBDC’s benefits and risks is sensitive to two considerations that appear in the Fed’s analysis either explicitly or implicitly. First, CBDC may be a less risky alternative to stablecoins, should regulation of the latter prove politically infeasible (see our earlier post). Second, if other highly trustworthy financial jurisdictions (with convertible currencies, credible property rights protections, and free cross-border flow of capital) offer their own CBDC, the case for a U.S. CBDC—as a device to sustain widespread use of the dollar—would become stronger.

Against this background, we applaud the Fed’s conservative approach. Most important, the U.S. authorities are not rushing to act. Instead, they are thinking carefully about the design elements, are actively engaged in public outreach, and have committed not to proceed without first securing broad public support….

Fed Monetary Policy in Crisis

The Federal Open Market Committee (FOMC) is facing a crisis of its own making. The crisis has four elements. Policymakers failed to forecast the rise in inflation. They failed to appreciate how persistent inflation can be. They are failing to articulate a credible low inflation policy. And, so far, there is little sign that monetary policymakers recognize the need to react decisively.

Our fear is that matters have now progressed to the stage where the Fed’s credibility for delivering price stability is at serious risk. And, as experience teaches us, the less credible the central bank, the more painful it is to lower inflation to target.

In this post, we discuss the policy crisis and suggest how to respond. In our view, the FOMC needs a plan to raise rates quickly and substantially. For the FOMC to ensure inflation returns to its target of 2%, policymakers likely will need to bring the short-term real interest rate into significantly positive territory. Put slightly differently, we suspect that the policy rate needs to rise to at least one percent above expected inflation.

Won’t a sharp policy tightening trigger a huge recession? In our view, credibility is the key to how much pain disinflation will cause. Applying the painful lesson of the 1970s and early 1980s leads us to conclude that the FOMC now needs to show clear resolve. Inflation rose very quickly over the past year, so it may still be possible to bring it down sharply without a recession. The more decisively policymakers act, the lower the long-run costs are likely to be. Failure to restore price stability in a timely way would almost surely render this expansion disturbingly short compared to recent norms.

From Inflation Targeting to Employment Targeting?

Last year, the Federal Open Market Committee (FOMC) modified its monetary policy framework to focus on average inflation targeting. They stated that “appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time” after “periods when inflation has been running persistently below 2%.” At the same time, the Committee scaled back efforts to preempt inflation, introducing an asymmetric “shortfall” strategy which responds to employment only when it falls below its estimated maximum. FOMC participants view these strategic changes as means to secure their legally mandated dual objectives of price stability and maximum employment (see our earlier posts here and here).

Prior to this week’s FOMC meeting, the Committee’s forward guidance explicitly balanced these two goals. However, in what we view as a remarkable shift, changes in the December 15 statement are difficult to square with any type of inflation targeting strategy. Despite the recent surge of inflation, the Committee’s new forward guidance removes any mention of price stability as a condition for keeping policy rates near zero. Instead, it focuses exclusively on reaching maximum employment.

In this post, we provide two reasons why such an unbalanced approach is concerning. First, a monetary policy strategy that ranks maximum employment well above price stability is unlikely to secure price stability over the long run. Second, FOMC participants’ projections for 2022-24 are a combination of strong economic growth, further labor market tightening and a policy rate well below long-run norms. This mix seems inconsistent with the large decline in trend inflation that participants anticipate. While policymakers certainly can and do revise their projections, persistent underestimates of inflation fuel the perception that price stability is a secondary, rather than equal, goal of policy….

Inflation Policy

“Headline” inflation is making painful headlines again. In October, consumer prices rose by 6.2 percent from a year ago—the most rapid gain in at least three decades. Measures of trend inflation also are showing unsettling increases, with the trimmed mean CPI up by 4%. And there are reasons to believe that inflation will stay well above policymakers’ 2% target for an extended period.

In this post, we briefly summarize how we got here and argue that the Federal Reserve needs to change course now. In our view, current monetary policy is far too accommodative. Moreover, the sooner the Fed acts, the more likely it is that policymakers will be able to restore price stability without undermining the post-COVID expansion.

Central Banks and Climate Policy

Avoiding a climate catastrophe requires an urgent global effort on the part of households, firms and governments to reduce our reliance on fossil fuels. Like many economists, we support a carbon tax. We also favor generous fiscal support for R&D to substitute for fossil fuels and remove carbon from the atmosphere.

What role should central banks play in this global effort? That is the prime focus of this post. We argue that central banks must preserve the independence needed for effective monetary policy. That implies only a modest role in addressing climate change.

Central banks are involved in both financial regulation and monetary policy. In each case, there are some things that central bankers can and should do to help counter the threat posed by climate change. As financial regulators, they should implement an improved disclosure regime and develop tools to ensure the financial system is resilient to climate risks.

In conducting monetary policy, central bankers should follow a simple, powerful principle: do not influence relative prices. To be sure, it is and should be standard practice to use interest rates to influence relative prices between consumption today and tomorrow. However, central banks ought not influence relative prices among contemporaneous activities. We will see that achieving this form of relative price neutrality may require central bankers to shift the composition of their assets and to alter the treatment of collateral in their lending operations….

Commentary

Money, Banking, and Financial Markets