With each passing year it becomes more and more obvious that the current Federal Reserve policy regime is finished, and that a new regime will be needed.
The existing regime at the Fed relies on using interest rate control to steer monetary policy. But they are also reluctant to cut nominal rates below zero. That means that in a world of low real interest rates (which describes the world of the 21st century) the Fed will not be able to use monetary policy during recessions, if they maintain a low inflation target.
There are several possible solutions. One solution (favored by Krugman and Blanchard) is to raise the inflation target to 4%. Another possible solution is NGDPLT. Or NGDP futures targeting. But whatever the Fed decides, one thing is clear—the current policy regime is bankrupt. The Fed hasn’t yet figured this out, but I suspect that at some level the markets have. Not that market participants necessarily agree with my specific MM intellectual framework, but rather that they see the failure of the current regime.
I’m told that lots of market participants think low inflation is now a structural characteristic of the global economy, and cite all sorts of factors like cheap imports. Of course that’s nonsense, inflation is never a structural problem, it’s a policy choice. I think what they are actually intuiting is that the Fed is wrong—under the current policy regime we will have very low inflation for as far as the eye can see. And we are seeing that in the bond market.
Today the 30-year TIPS spread fell to 1.71%, a record low. The 30-year bond yield is 2.74%. At those rates the Fed won’t be able to use the short term nominal interest rate as a policy instrument during recessions. The markets are telling the Fed that its policy regime no longer works. Is the Fed listening?
Update: The 30-year TIPS spread is not a record low, I relied on a FRED time series that only went back a few years.