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….

Patience vs FAIT: Which is key in the new FOMC strategy?

The Federal Open Market Committee’s (FOMC) policy strategy update incorporates two key changes. The first is a shift to flexible average inflation targeting (FAIT), while the second is a move to what we will call a patient shortfall strategy. FAIT represents a shift in the direction of price-level targeting in which the FOMC intends to make up for past inflation misses (see our previous post). As Fed Governor Brainard recently explained, the strategy of increased patience, embedded in language that focuses on employment “shortfalls” rather than “deviations,” reflects reduced willingness to act preemptively against inflation when the unemployment rate (u) declines below estimates of its sustainable level (call it u*).

The Committee will need to explain what these two changes mean for the determinants of policy—what we think of as their reaction function. For example, FAIT implies that the FOMC’s short-term inflation objective will change over time—possibly even from meeting to meeting. For the policy to have its intended impact of shifting inflation expectations, we all need to know the Fed’s inflation target. Similarly, having downgraded the role of the labor market as a predictor of inflation, the central bank will need to explain how it aims to control inflation going forward. While patience is the broad message, pointing to a more backward-looking approach to control, it seems likely that attention will shift to other inflation predictors. But again, if this shift is to have the intended impact on expectations, it is important that the Fed be clear about how it is forecasting inflation.

In this post, we compare the practical importance of these two strategic shifts. Our conclusion is that, while neither appears very large on average, the patient shortfall strategy looks to be the more important of the two….

Inflation risks and inflation expectations

U.S. inflation has been low and steady for three decades. This welcome stability is not merely a consequence of good fortune. Shocks that in the past might led to higher trend inflation—like the energy price increases—continue to buffet the economy much as they did in the 1970s and 1980s, when inflation rose to a peacetime record. Rather, it reflects the improved monetary policy of the Federal Reserve, which began acting as an inflation-targeting central bank in the mid-1980s, long before it announced a 2% target for inflation in 2012. As a consequence of the Fed’s sustained efforts, long-run inflation expectations have remained close to 2% for more than 20 years. One result is that temporary disturbances that drive inflation above or below target quickly fade.

This is the optimistic conclusion of the 2017 U.S. Monetary Policy Forum (USMPF) report. Since the adoption of the de facto inflation-targeting regime, one-off shocks have little impact on the inflation trend. Moreover, as many have observed, the relationship between unemployment and inflation—the Phillips curve (see our primer)—is now notably weaker. However, the authors of that earlier report warn that the Phillips curve “flattening” could be a direct consequence of the Fed’s success. Furthermore, since the sample period from 1984 to 2016 excludes any sustained period of a very tight economywide labor market, it would not be possible to detect an outsized impact, if any, of persistently low unemployment on inflation.

Enter the 2019 USMPF report, which focuses on the possibility that inflation may indeed respond differently when the unemployment rate is very low and projected to remain low for several years (see, for example the FOMC’s latest Summary of Economic Projections). The logic is straightforward: if labor is very scarce for an extended period, employers will bid up wages and (unless they are prepared to accept declining profits) pass on those cost increases in the form of higher prices….

Inflation Policy

Inflation in the United States remains at levels that most people don’t really notice. Overall, the consumer price index rose 2.8 percent from May 2017 to May 2018. And, when you look at core measures, the trend is still below 2 percent.

With inflation and inflation expectations still so benign, it is no wonder that despite solid economic growth and the lowest unemployment rate in 50 years the Federal Open Market Committee continues to act quite gradually (see their June 2018 statement). Inflation could well turn up in the near term—perhaps by more than the policymakers expect. But, for reasons that we will explain, if we were on the FOMC, we would stay the planned course: remain vigilant, but certainly not panic.

We start with a look at the data. What we see is that trend inflation has stayed reasonably close to the Fed’s medium-term target of 2 percent for the past two decades. There have been occasional deviations, like the temporary rise in 2008 and again in 2011, but overall, the path is remarkably stable….

The case for a higher inflation target gets stronger

For several years, economists and policymakers have been debating the wisdom of raising the inflation target. Today, roughly two-thirds of global GDP is produced in countries that are either de jure or de facto inflation targeters (see our earlier post). In most advanced economies, the target is (close to) 2 percent. Is 2 percent enough?

Advocates of raising the target believe that central banks need greater headroom to use conventional interest rate policy in battling business cycle downturns. More specifically, the case for a higher target is based on a desire to reduce the frequency and duration of zero-policy-rate episodes, avoiding the now well-known problems with unconventional policies (including balance sheet expansions that may prove difficult to reverse) and the limited scope for reducing policy rates below zero.

We have been reticent to endorse a higher inflation target. In our view, the most important counterargument is the enormous investment that central banks have made in making the 2-percent inflation target credible. Yet, several lines of empirical research recently have combined to boost the case for raising the target….

Commentary

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