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….

Monetary Policy in the Next Recession?

In many advanced countries, lowering the policy rate to zero will be insufficient to counter the next recession. In the United States, for example, with the target range for the federal funds rate at 1½ to 1¾ percent, there is little scope for the nearly 5 percentage-point easing that is typical in recent recessions (see, for example, Kiley).

This is the setting for this year’s report for the U.S. Monetary Policy Forum, written with Michael Feroli, Anil Kashyap and Catherine Mann. Our analysis focuses on the extent to which the “new tools” of monetary policy—including quantitative easing, forward guidance and negative interest rates—have been associated with an improvement of financial conditions. The idea is that the transmission of monetary policy to economic activity and prices works primarily through its effect on a broad array of financial conditions.

The USMPF report does not challenge the views of many researchers and of most central banks that the new monetary policy (NMP) tools have an expansionary impact even at the effective lower bound for nominal interest rates (see also the 2019 report from the Committee on the Global Financial System). However, we find that these new tools generally were not sufficient to overcome the powerful headwinds that prevailed in many advanced economies over the past decade.

Our conclusion is that central bankers should clearly incorporate the new tools in their reaction functions and communications strategies, but should be humble about their likely success in countering the next recession, at least in the absence of other supportive actions (such as fiscal stimulus)….

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….

Relying on the Fed's Balance Sheet

Last week’s 12th annual U.S. Monetary Policy Forum focused on the effectiveness of Fed large-scale asset purchases (LSAPs) as an instrument of monetary policy. Despite notable disagreements, the report and discussion reveal a broad (if not universal) consensus on key issues:

In a world of low equilibrium real interest rates and low inflation, policymakers could easily hit the zero lower bound (ZLB) in the next recession.

At the ZLB, the Fed should again use a combination of balance-sheet tools and interest-rate forward-guidance to achieve its mandated objectives of stable prices and maximum sustainable employment (see our earlier post).

Yet, significant uncertainties about the impact of balance-sheet expansion mean that LSAPs may not provide sufficient stimulus at the ZLB.

Fed policymakers should undertake a thorough (and potentially lengthy) assessment of alternative policy tools and frameworks—ranging from negative interest rates to a higher inflation target to forms of price-level targeting—to ensure they remain as effective as possible.

The remainder of this post discusses the challenges of measuring the impact of balance-sheet policies. As the now-extensive literature on the subject implies, balance-sheet expansions ease financial conditions. However, as this year’s USMPF report emphasizes, there is substantial uncertainty about the scale of that impact....

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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