Zero lower bound

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.

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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….

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The Fed's New Strategy: More Discretion, Less Preemption

On August 27, marking the conclusion of the Fed’s first strategic review, the Federal Open Market Committee released an amended version of their fundamental policy guide—the Statement on Longer-Run Goals and Monetary Policy Strategy. The FOMC adopted a form of flexible average inflation targeting (FAIT). Partly because the new strategy largely confirms recent Fed behavior, the response in financial markets was minimal. Indeed, market-based long-run inflation expectations were virtually unchanged this week. Perhaps the only noticeable development was a modest steepening at the very long end of the yield curve.

In this post, we identify three key factors motivating the Fed review and highlight three principal shifts in the FOMC’s strategy. In addition, we identify several critical questions that the FOMC will need to answer as it seeks to implement the new policy framework. Specifically, the shift to FAIT implies a change in the Committee’s reaction function. How does this reformulated objective influence the FOMC’s systematic response to changes in economic growth, unemployment, inflation and financial conditions? Under FAIT, the effective inflation target over the coming years also now depends on past inflation experience. What is that relationship?

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Average Inflation Targeting

The Federal Open Committee’s first-ever comprehensive monetary policy review looks to be coming to an end. Since the announcement on November 15, 2018, the Fed has focused on strategies, tools, and communications practices, and engaged the public through numerous Fed Listens events, including a conference at which invited experts proposed new approaches (see our earlier post). At its July meeting, the FOMC discussed potential changes to its Statement on Longer-Run Goals and Monetary Policy Strategy—the “foundation for the Committee’s policy actions”—with the aim of finalizing those changes soon. And, Chairman Powell is scheduled to speak this week about the “Monetary Policy Framework Review” at the annual Jackson Hole Economic Policy Symposium.

Perhaps the most important issue on the review agenda is the FOMC’s inflation-targeting strategy. Since 2012, the FOMC has explicitly targeted an inflation rate of 2% (measured by the price index of personal consumption expenditures). A key objective of FOMC strategy is to anchor long-term inflation expectations, contributing not only to price stability, but also to “enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.” Yet, since the start of 2012, PCE inflation has averaged only 1.3%, prompting many policymakers to worry that persistent shortfalls drive down expected inflation (see, for example, Williams). And, with the Fed’s policy rate now back down near zero, falling inflation expectations raise the expected real interest rate, tightening financial conditions and undermining policymakers’ efforts to drive up growth and inflation.

In this note, we discuss one alternative to the current approach that has gained wide attention: namely, average inflation targeting. The idea behind average inflation targeting is that, when inflation falls short of the target, it creates the expectation of higher inflation. And, should inflation exceed its target, then it would reduce inflation expectations. Even when the policy rate hits zero, the result is a countercyclical movement in real interest rates that enhances the effectiveness of conventional policy….

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The Case for Strengthening Automatic Fiscal Stabilizers

For decades, monetary economists viewed central banks as the “last movers.” They were relatively nimble in their ability to adjust policy to stabilize the economy as signs of a slowdown arose. In contrast, discretionary fiscal policy is difficult to implement quickly. In addition, allowing for the possibility of a constantly changing fiscal stance adds to uncertainty and raises the risk that short-run politics, rather than effective use of public resources, will drive policy. So, the ideal fiscal approach was to set policy to support long-run priorities, minimizing short-run discretionary changes that can reduce economic efficiency.

Today, because conventional monetary policy has little room to ease, the case for using fiscal policy as a cyclical stabilizer is far stronger. Unless something changes, there is a good chance that when the next recession hits, monetary policymakers will once again find themselves stuck for an extended period at the lower bound for policy rates. In the absence of a monetary policy offset, fiscal policy is likely to be significantly more effective.

Against this background, a new book from The Hamilton Project and the Washington Center for Equitable Growth, Recession Ready: Fiscal Policies to Stabilize the American Economy, makes a compelling case for strengthening automatic fiscal stabilizers. These are the tax, transfer and spending components that change with economic conditions, as the law prescribes….

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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….

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Banks and Money, Or Watch out What You Wish For

On 10 June 2008, a large majority of voters in Switzerland rejected a proposal that all commercial bank demand deposits be held at the central bank. This Vollgeld referendum was another incarnation of the justifiable public revulsion to financial crises and the bailouts that inevitably accompany them. Vollgeld proponents claimed that a system in which the central bank is the sole issuer of “money” will be more stable.

Serious people debated the wisdom of this proposal. One of Switzerland’s premier monetary economists, Philippe Bacchetta, wrote passionately in opposition. Martin Wolf, chief economics commentator at the Financial Times, argued in favor. And Swiss National Bank Chairman Thomas Jordan discussed the many dangers in detail.

It should come as no surprise that, had we had been among the Swiss voters, we would have voted “no.” In our view, the Vollgeld (sovereign money) initiative combined aspects of narrow banking with those of retail central bank digital currency. We see these as misguided, distorting the credit allocation mechanism and more likely to reduce than improve financial stability (see here and here). In the remainder of this post, we explain why….

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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.... 

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A Monetary Policy Framework for the Next Recession

Hope for the best, but prepare for the worst. That could be the motto of any risk manager. In the case of a central banker, the job of ensuring low, stable inflation and high, stable growth requires constant contingency planning.

With the global economy humming along, monetary policymakers are on track to normalize policy. While that process is hardly free of risk, their bigger test will be how to address the next cyclical downturn whenever it arrives. Will policymakers have the tools needed to stabilize prices and ensure steady expansion? Because the equilibrium level of interest rates is substantially lower, the scope for conventional interest rate cuts is smaller. As a result, the challenge is bigger than it was in the past.

This post describes the problem and highlights a number of possible solutions.

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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….

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How Low Can They Go?

Not long ago, nearly everyone thought that nominal interest rates could not go below zero. Now, we have negative policy rates in the euro area and Japan, while in Sweden and Switzerland, the lowest controlled rate is below -1%. And government securities worth trillions of dollars bear negative rates, too.

When we first wrote about negative rates a year ago, we argued that the effective lower bound (ELB, rather than ZLB) for nominal rates was determined by the transactions costs of storing and transferring cash. We reasoned that the ELB might be in the range of -0.50% (minus one-half percent). Below that, we thought, there would be a move into cash, facilitated by banks and others who efficiently manage the notes for clients.

But, at the negative rates that we have seen so far, cash in circulation has not spiked. So, how much further can nominal interest rates fall? And what role should negative interest rates play in the future?

 

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Negative nominal interest rates: back to the future?

Goldsmiths were the forerunners to modern bankers. Originally, they would issue receipts to certify gold was deposited in their vaults. These eventually gave rise to fractional reserve banking, as goldsmiths used a portion of the gold to make loans.

Well, we might be on our way back to the original version, but instead of keeping our gold safe, banks will be keeping our dollar, Swiss franc, yen, and euro notes safe!

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