From the Financial Times:
The Fed chair said she expected inflation to return to a 2 per cent annual rate over the next few years as temporary influences wane.
Why? What will cause inflation to return to 2%?
Ms Yellen added that there were financial stability risks to holding rates at ultra-low levels for too long.
“Continuing to hold short-term interest rates near zero well after real activity has returned to normal and headwinds have faded could encourage excessive leverage and other forms of inappropriate risk-taking that might undermine financial stability.”
Why would low rates encourage excessive risk taking? And if they do, how does the Fed remedy that situation? Do they raise rates for a couple years, at the cost of lower rates for a couple decades, or do they lower rates for a couple years, at the cost of higher rates for a couple decades? Where is the model? How do they get from here to there?
“Reducing slack along these other dimensions may involve a temporary decline in the unemployment rate somewhat below the level that is estimated to be consistent, in the longer run, with inflation stabilising at 2 per cent,” Ms Yellen said.
Allowing the unemployment rate to fall below its long-run level for a period could also have the benefit of “speeding the return to 2 per cent inflation”, Ms Yellen argued. It could have the extra positive of reversing some of the supply-side damage suffered by the US economy in recent years.
Since when has the Phillips Curve been a reliable model for predicting inflation?
Keynesianism is usually considered a “liberal” model. That’s a bit misleading, as most conservative economists also use a Keynesian framework for analyzing the economy. They talk about the various sectors of the economy; consumption, government, net exports, etc. They worry that monetary policy is ineffective at the zero bound. They think inflation is caused by low unemployment. They think low interest rates can lead to excessive risk taking.
In fact, except in the very short run, interest rates reflect the conditions of economy, not the stance of monetary policy. Inflation is not caused by low unemployment, but rather by excessive NGDP growth.
The latest TIPS spreads have fallen to shockingly low levels:
5 Year TIPS spread = 1.19%
10 year TIPS spread = 1.50%
30 year TIPS spread = 1.69%
Recall that the Fed’s CPI inflation target is around 2.3% (give or take a few tenths.) These TIPS spreads call for monetary easing, or else the Fed may soon lose credibility.
Fortunately there is a ray of hope:
“Inflation may rise more slowly or rapidly than the committee currently anticipates; should such a development occur, we would need to adjust the stance of policy in response,” Ms Yellen said at the Philip Gamble Memorial Lecture University of Massachusetts, Amherst.
If this happens (and pretty I’m confident it will) then the Fed needs to do more than “adjust the stance of policy.” The Fed needs to rethink its entire approach to policy. The Fed needs to define what they mean by “the stance of policy.” The Fed needs to revisit past decisions, and figure out what they did wrong. I hope they will look at what their critics have been saying. Then the Fed needs to start setting the stance of policy at a position where the markets expect the Fed to succeed.
PS. I understand the Fed has a dual mandate, and I don’t think it’s a big deal if they undershoot their inflation target for a couple straight years. I do think it’s a big deal if they undershoot for a couple straight decades, as the Japanese have done, and the Europeans are doing. I expect more from the Fed, especially as they’ve had the benefit of seeing what happened with other central banks, when they tried to raise rates above the Wicksellian equilibrium rate.