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 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….

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.

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.

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….

Qualifying for the Fed

Monetary economists of nearly all persuasions are overwhelming in their condemnation of President Trump’s desire to appoint Stephen Moore and Herman Cain to vacant seats on the Board of Governors of the Federal Reserve. The full-throated case for a high-quality Board offered by Greg Mankiw—former Chief of the Council of Economic Advisers under President George W. Bush—is just one compelling example.

Rather than review President Trump’s picks, in this post we enumerate the key qualities that we believe make a person well suited to serve on the Board. Before getting to any details, we should emphasize our strongly held view that there is no simple prescription—in law or practice―for what makes a successful Federal Reserve Governor. Furthermore, no single person combines all the characteristics needed to make for a successful Board. For that, diversity in thought, preferences, frameworks, decision-making, and experience is essential.

With the benefits of diversity in mind, we highlight three common characteristics that we consider vital for anyone to be an effective Governor (or Reserve Bank President). These are: a deep respect for the Fed’s legal mandate; a clear understanding of an analytic framework that makes policy choices reasonably predictable and effective; and an open-mindedness combined with humility that tempers the application of that framework….

Dot-ology: What can we learn from the dot plot?

The primary objective of monetary policy is to keep inflation and unemployment low and stable. To be effective, central bankers must address shocks to inflation and unemployment, while ensuring that what they say and do is not a source of volatility. One way to make a commitment to stability credible is for policymakers to broadcast their likely responses to shocks—their reaction function. Such transparency escalates the cost of reneging, helping to anchor expectations about the future that influence current behavior (see our primer on time consistency). And, because they can anticipate how policy will respond to changes in economic and financial conditions, it improves everyone’s economic and financial decisions.

With such a stability-oriented policy strategy, the policy path will depend on what happens in a changing world. Only under specific circumstances―such as when the short-term interest rate is at or near its effective lower bound―will policymakers be inclined to commit to a specific future policy path.

Recently, we wrote about the remarkable evolution of Federal Reserve monetary policy communication over the past quarter century. Today, the Federal Open Market Committee (FOMC) publishes statements, minutes, and quarterly forecasts for growth, inflation, unemployment, and interest rates. In this post we take up a narrow question: What can we learn from the information published in the FOMC’s quarterly Summary of Economic Projections (SEP)?

Our answer is: quite a bit. The data allow us to estimate not only an FOMC reaction function, but also a short-run projection of the equilibrium real rate of interest (r*)―one that is consistent with projected economic conditions over a two- to three-year horizon—in addition to the long-run r* that is implicit in each SEP. While there is almost surely room to improve on the SEP, we conclude, as a friend and expert Fed watcher once suggested, “Don’t ditch the dots” ….

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….

Trump v. Fed

Last month, interrupting decades of presidential self-restraint, President Trump openly criticized the Federal Reserve. Given the President’s penchant for dismissing valuable institutions, it is hard to be surprised. Perhaps more surprising is the high quality of his appointments to the Board of Governors. Against that background, the limited financial market reaction to the President’s comments suggests that investors are reasonably focused on the selection of qualified academics and individuals with valuable policy and business experience, rather than a few early-morning words of reproof.

Nevertheless, the President’s comments are seriously disturbing and—were they to become routine—risk undermining the significant benefits that Federal Reserve independence brings. Importantly, the criticism occurred despite sustained strength in the economy and financial markets, and despite the stimulative monetary and fiscal policies in place….

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