The US Federal Reserve has announced that it will conduct a root and branch review of its monetary policy framework in the next 18 months. The results could be of first order importance for financial markets, especially the bond market.
Richard Clarida, the Fed’s vice-chairman said last month that the motivation was not any great dissatisfaction with the present policy. Both of the twin objectives — maximum employment and stable prices — were close to target.
Instead, the Federal Open Market Committee seems concerned that inflation is failing to respond to recovering economic activity, implying that it might be difficult to cope with even lower inflation when the economy next enters a recession.
The fact that US inflation has not responded to sharply falling unemployment levels, sometimes known as the disappearance of the Phillips Curve, is often described as a puzzle. However, that word is misleading, since a great deal of recent research has established the main reasons for the loosening of this relationship.
Structural factors such as the effects of the internet and Chinese imports on goods prices have been important. But a key conclusion is that the growing credibility of the Fed’s 2 per cent inflation target has anchored inflation expectations, so that any temporary fluctuations in inflation and economic activity are ignored. In the decades before 1990, inflation shocks were often “accommodated” by monetary policy, altering expectations, and causing substantial spikes in inflation.
This change in the inflation mechanism is a good thing, but it means that the FOMC cannot rely on easily controlling inflation by adjusting economic activity and unemployment, via interest rate policy. In an extreme case where inflation does not respond at all to unemployment, inflation becomes indeterminate, spelling the end of monetary policy as we know it.
The Fed does not believe that the US has reached this extreme state. The most influential members of the FOMC believe the Phillips Curve is “alive and well”. But they think that the flattening in the curve emphasises the importance of keeping inflation expectations anchored to the 2 per cent target, whether inflation shocks are upwards or downwards.
At present, there is no sign of any upward shift in inflation expectations but the FOMC is concerned that expectations may drop well below the 2 per cent target during the next recession.
This is because the effective lower bound on nominal interest rates is fairly close to zero, while the equilibrium level of interest rates (r*) is also lower than before. Because of this combination, it may be hard to offset a large deflationary shock by lowering interest rates far enough below equilibrium. Eventually that might lead to a permanent drop in inflation expectations, as has occurred in Japan and more recently the eurozone (see box).
The main focus of the Fed’s review can therefore be loosely summarised as follows: how can the monetary regime prevent the US from morphing into the eurozone or Japan during the next recession?
One idea for avoiding the Japanese deflationary trap is simply to raise the existing inflation target from 2 per cent to 3-4 per cent, but Mr Clarida has specifically ruled this out. The current mechanism always aims for 2 per cent inflation in the period immediately ahead, and does not compensate for any shortfalls in the past. This leads to a downwards bias in the actual path for inflation over long periods.
Instead, the central bank could target the average inflation rate at 2 per cent in the long term. When prices fall below the long-run 2 per cent target during a recession, the Fed would credibly commit to compensating for this error during the subsequent recovery.
Forward guidance would be reinforced, and policy would be kept easier for longer, until prices got back on to the 2 per cent track. This would mean that the short run inflation rate may exceed 2 per cent while the catch-up to the long-term path occurs.
The FOMC is already moving in this direction with recent policy decisions. The main question is how they should formalise the new regime, such that it survives the difficult political tests when inflation temporarily rises to more than 2 per cent during the catch-up periods. Former Fed chairman Ben Bernanke has made influential suggestions about this but the details are open for debate.
There will also be discussion about new policy instruments to make the effectiveness of the new regime credible, especially at times when interest rates are at the effective lower bound, and quantitative easing is fully utilised.
The leading idea appears to the imposition of Japanese-style bond-yield ceilings, enforced by unlimited central bank buying of bonds.
Remarkably, that would take the Fed back to its pre-1951 regime, under which it committed to support the war effort by buying enough Treasury securities to keep long bond yields under 2.5 per cent, whatever the stance of fiscal policy. That nuclear option will not be used outside a big economic emergency, but it is interesting that it is even mentioned as the review gets under way.
What would be the market consequences of long-term “average” inflation targeting?
The tail risk of endemic deflation would decline, and long-term inflation expectations might be slightly higher than before. This would help risk assets.
The volatility of inflation and bond yields would decline still further.
The average level of nominal bond yields might be little changed, but inflation break-evens would rise while real yields decline, reflecting the longer periods of easier monetary policy that would be needed to allow the phases of inflation catch-up to occur.
The bigger the next deflationary shock, the greater these effects would be.
The collapse in inflation volatility after 1990 in advanced economies
Inflation volatility in the US has plummeted, with core inflation settling close to the 2 per cent target.
In the eurozone, inflation has become stuck at 1 per cent, well below target.
In Japan, the situation is even worse, with inflation fixed permanently at zero.
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