Suppose the Fed always aims for 2% inflation
Tim Duy has a good post explaining why the Fed is unlikely to opt for “overshooting.”
I was re-reading some of the recent overshooting debate and it occurred to me that it is comical that we are even having this discussion. The Fed is not going to deliberately overshoot inflation, period. That train left the station long ago. So long ago that you can’t even here the rumble on the tracks.
The train left the station on January 25, 2012, with this statement by the Federal Reserve:
The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.
On that day, the Federal Reserve locked in the definition of price stability. They locked it in specifically to prevent even the appearance they might deliberately overshoot as a result of extraordinary monetary policy. They locked it in as a commitment device to tie the hands of future policymakers as they would need to justify changing the definition of price stability, presumably a very high bar for any central banker to cross.
That’s probably correct. But it does point to some confusion at the Fed. The Fed seems pretty committed to their dual mandate, but doesn’t seem to understand what it implies. Let’s start with a simple policy rule. Suppose the Fed never aimed for above target inflation. Also suppose they aim for 2% inflation, on average. In that case it would be a logical necessity for the Fed to never aim for below 2% inflation. Which means that they would always have to aim for exactly 2% inflation going forward.
Now that is a defensible policy (although I would oppose it.) But it certainly is not a policy consistent with a dual mandate. It would be a single mandate inflation target (IT), pure and simple. Fed officials often seem confused on that point. They talk about the need to aim for 2% inflation, even when unemployment is high. But that means they are behaving exactly as they would behave if Congress had given them an IT single mandate. In other words, they are behaving exactly as they would if their mandate was set by the right wing of the Republican Party. Even now, under Janet Yellen, the tapering and prospective interest rate hikes are aimed at boosting inflation back up to 2%. The policy is exactly the same as it would be if the Fed did not care about unemployment at all.
I suppose 99% of people would look at this picture and see all sorts of grand conspiracies. The Fed is in the back pocket of the bankers, the bondholders, the creditors, the coupon clippers. But I’m different, I’m a hopelessly naive fool who actually thinks the Fed is trying to do a good job, but just lost its way. And why do I believe the Fed is actually not corrupt, despite all the evidence pointing to their violation of the dual mandate over the past 5 years? Two reasons:
1. The top Fed officials tend to be economists. Both actual voters like Bernanke and Yellen, and also the all important staff people who set the agenda.
2. As far as I can tell the vast majority (not all) of economists who are not at the Fed, who have no financial interest at all in helping bankers, even economists who favor increased welfare spending, a higher minimum wage, help for the unemployed, and all sorts of other left wing causes, seem equally confused about monetary policy as the economists who are at the Fed.
So one possibility is that clueless economists join the Fed, and instantly become both highly intelligent and corrupt at the same moment. That’s what the critics who call me naive seem to think. However I think it much more likely that when they join the Fed their competence and honesty don’t change very much. They are trying their best, and making the same mistakes as their private sector counterparts make when asked about monetary policy. They think it’s “natural” that we have deflation in a deep slump like 2009, whereas their mandate actually implies that inflation should be countercyclical; above target when unemployment is high, and vice versa.
If this interpretation seems naive, then I plead guilty.
PS. Tim Duy has another good post on this subject:
If the most dovish member of the FOMC can tolerate no more than a 25bp upside miss on inflation, what does it say about the other FOMC members? Regardless of whether this is Kocherlakota’s max or the best he thinks he can get, it tells you that 2% is really a ceiling, not a target. Now, generously, it maybe that the FOMC believes that they cannot exceed 2% politically given the amount of extraordinary stimulus already in place. But that still leaves 2% as a ceiling.
PPS. I do realize there are lots of other interpretations (none good.) For instance, the bubbleheads may have gained influence, and the worry about bubbles may be roughly offsetting worry about unemployment, leaving us with a 2% inflation target (which we will likely fall short of.)
HT: Travis V
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21. March 2014 at 12:14
Excellent blogging.
If you ask Fed to choose between 10 years of 3 percent real growth and 3 percent inflation, of 10 years of 1.5 percrnt real growth and 1.5 percent inflation, they will choose the latter…
The 1.5 percent inflation/growth scenario is within policy targets…
The nutty thing is most modern USA economists would agree with that choice…except to say, perhaps, that zero percent inflation should be the target…
21. March 2014 at 12:45
Krugman also writing about 2% inflation targets today.
http://krugman.blogs.nytimes.com/2014/03/21/timid-analysis-wonkish/?_php=true&_type=blogs&_r=0
21. March 2014 at 13:28
It is also a “grand conspiracy” theory that the Fed is benevolent and non-corrupt.
The owners of the Fed are not economists. They are bankers. Politicians ensure this remains unchanged.
The owners have the control. The Fed chief is the public figurehead to placate gullible people into believing pretty much exactly what you believe in.
In actual fact the Fed engages in secret activity that the FOMC is not privy to. I say this because the Fed’s owners, and their FOMC lapdogs, refuse to be fully audited. There is absolutely no way that a governmental central bank is not used for nefarious purposes. Its very existence is predicated on initiating violence and coercion against innocent people, which is very much nefarious.
The Fed is not a free market institution. It is literally impossible for it to be benevolent. Benevolence and non-corruption require, as a minimum, abstentions from violence and coercion.
The Fed engages in “black ops” financing. It was a stroke of luck that it was learned through a watered down and almost totally ineffectual Fed audit bill, that the NY Fed secretly (at the time) sent over $40 billion to Iraq to finance “reconstruction” 2003-2008. It bailed out bankers with a cumulative total of over $9 trillion in “emergency” loans. Of course, they have also worked overtime, with the help of economists who go through the inflationist ringer at schools like Chicago, to convince the public that what is good for the bankers is good for the working class. Convenient isn’t it? Helping themselves and their mistaken investments, helps everyone else.
Imagine a tinpot dictator claiming that a central bank which inflated the dictator’s bank account and his lavish spending on himself “helps the economy” because the money spends would then be spent by others.
Now replace that dictator with a banker. Nothing changes in terms of how bats%&t insane it is.
Sumner’s attempt to deny the Cantillon Effect is, as I said before, an epic case of cognitive dissonance. Cantillon Effects are real. It is what enables bankrupt bankers to outcompete all competitors for that bank’s assets.
And we’re supposed to welcome this because “it’s better than nothing.”
The real Fed has NOTHING to do with any “dual mandate.”
Excuse me, but have you not read any studies on how the Fed has become the majority financier of monetary policy research?
See “The Federal Reserve System’s Influence on Research in Monetary Economics”, by Lawrence White
If climate “scientists” can become corrupt, so too can economists, if not more so.
Most economists who are paid to study monetary policy have what you have Sumner: An intellectual and financial vested interest in promoting and defending the Fed against calls for its abolition.
No, these economists are already intellectually corrupted to think obediently and dutybound to the banks and Congress, both of whom are the beneficiaries of the monopoly system.
If you are anti-Federal Reserve and anti-Federal Reserve System Banker, you cannot and will not become a member of the FOMC, let alone sweep the floors. This should be obvious.
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The elephant in the room sized difference being that when the economists of the Fed make mistakes, the bulk of the population suffers the consequences, because the Fed holds a monopoly on money and it is coerced onto everyone via “pay me taxes in US dollars only or else” and “pay the plaintiff restitution in US dollars only”.
Contrast that with something like Bitcoins, and if an individual Bitcoin owner makes a mistake, then the negative effects on others are significantly less, because costs are more internalized in a context of private property rights. The costs of Fed mistakes arw externalized on the bulk of the population through coercion.
21. March 2014 at 13:39
Imagine the production of food, or life saving medicine, or shelter construction, being monopolized.
Then imagine the monopolist makes mistakes.
It is foolish to want any good or service monopolized. Economists are taught in first year university or college the problems of monopolies. And yet most of those same economists don’t apply any of this to money production. Now all of a sudden monopolies are good.
It’s a joke.
The reason decentralization is a good idea is precisely to minimize the effects of human error. Money is extremely important in society. I side with Milton Friedman who said “Money is much too important to be left to central bankers.”
21. March 2014 at 13:53
It appears I have been too optimistic in thinking the success of our intellectual arguments was translating into policy influence. Not the NGDP target that we sorely need, but at least an understanding of how money is/has been too tight and must be accommodative to return the labor market to more normal state.
Unfortunately, it looks like we will be mired into an under employment equilibrium and a recurring encounter with the Zero Lower Bound if the Fed decides to hike next year. Depressing.
21. March 2014 at 17:00
In reference to the Michael Byrnes comment above…
Paul Krugman says the following:
“Now, even in this case you can get traction if you can credibly promise higher inflation, which reduces real interest rates. But what does it take to credibly promise inflation? Well, it has to involve a strong element of self-fulfilling prophecy: people have to believe in higher inflation, which produces an economic boom, which yields the promised inflation.”
So once again, he is excessively focused on the Traditional Real Interest Rate Channel of the Monetary Transmission Mechanism (MTM).
Krugman mentions that he was a discussant, along with Bernanke of the following paper at the Brookings Panel meeting:
http://www.brookings.edu/~/media/projects/bpea/spring%202014/2014a_hausman.pdf
Abenomics: Preliminary Analysis and Outlook
Joshua K. Hausman and Johannes F. Wieland
March 2014
Abstract
“In early 2013, Japan enacted a monetary regime change. The Bank of Japan set a two percent inflation target and specified concrete actions to achieve this goal by 2015. Shinzo Abe’s government is supporting this change with fiscal policy and structural reforms. We show that Abenomics ended deflation in 2013 and raised long-run inflation expectations.
Our estimates suggest that Abenomics also raised 2013 output growth by 0.9 to 1.7 percentage points. Monetary policy alone accounted for up to a percentage point of growth, largely through positive effects on consumption. In the medium and long-run, Abenomics will likely continue to be stimulative.
But the size of this effect, while highly uncertain, thus far appears likely to fall short of Japan’s large output gap. In part this is because the Bank of Japan’s two percent inflation target is not yet fully credible. We conclude by outlining how to interpret future data releases in light of our results.”
Another paper, that was delivered at the Brookings Panel, that might be of some interest, if you haven’t already read the earlier edition, is the following one:
http://www.brookings.edu/~/media/projects/bpea/spring%202014/2014a_sheedy.pdf
Debt and Incomplete Financial Markets: A Case for Nominal GDP Targeting
Kevin D. Sheedy
March 2014
Abstract:
“Financial markets are incomplete, thus for many agents borrowing is possible only by accepting a financial contract that specifies a fixed repayment. However, the future income that will repay this debt is uncertain, so risk can be inefficiently distributed. This paper argues that a monetary policy of nominal GDP targeting can improve the functioning of incomplete financial markets when incomplete contracts are written in terms of money. By insulating agents’ nominal incomes from aggregate real shocks, this policy effectively completes the market by stabilizing the ratio of debt to income. The paper argues that the objective of nominal GDP should receive substantial weight even in an environment with other frictions that have been used to justify a policy of strict inflation targeting.”
21. March 2014 at 18:45
Completely off-topic (sorry about that): Did any of the journalists at Janet Yellen’s press conference ask her why the Fed is continuing to pay positive interest on reserves? Does any journalist ever ask a Fed Chair that question? I am baffled by the general lack of interest in this issue. (I care about it enough to raise it here, though I didn’t care enough to watch the actual press conference or read a transcript.)
21. March 2014 at 21:14
The RBA understands that inflation has to cycle around the target if unemployment is to be minimised. Since other central banks don’t really seem to, I am led to the conclusion that it is ultimately Australian pragmatism at work.
Australia has what appears to be the “most utilitarian political culture” on the planet, going back to the early days of European settlement but particularly through the influence of Chartism. Even the great policy shift away from the Deakinite Settlement (White Australia, Trade Protection, State Paternalism, Wage Arbitration, Imperial Benevolence) was about changing views in what worked for risk management. We are a predominantly Anglo-Celtic enclave clinging to the coasts of a water-short, drought, fire and flood prone island-continent at the end of Asia: hence practical risk management and state-as-giant-utility being at the centre of public policy. We also tend to be good at bureaucracy. (Perhaps a little too good.)
Hence a pragmatic central bank that takes a broad, utilitarian risk-management view. The US is a bit more inclined to grand ideas and creating fetishes of order. Inflation targeting is a clear fetish; the clearer the narrower it is.
New Zealand does not quite make it, because it is a (much) smaller country, so a bit more inclined to become swept up in the latest ideas. Especially since it is a unicameral non-federal state. The Australia is a Federation with a powerful Senate also encourages more persuasion and broadening-the-goodies compromise. More utilitarian pragmatism.
21. March 2014 at 21:19
That link was not done properly by moi:
http://www.jstor.org/discover/10.2307/20024958?uid=3737536&uid=374578147&uid=2129&uid=2&uid=70&uid=3&uid=60&sid=21103713768357
21. March 2014 at 22:02
I largely agree, Lorenzo, but even in Australia I constantly hear from financial markets types about how rates need to rise soon (both here and in the US) or else “it will end badly…”. Last year I attended a revision lecture given by the writer of the primary Victorian Year 12 economics textbook. He told the young attendees, without qualification, that a 4.5% (official cash) rate was ‘neutral’, so current rates (@2.5%) were ‘highly stimulatory’ despite the lowest NGDP and wages growth in two decades. Blogs and newspapers are filled with fears about our rising house prices, combined with anxiety about our disappearing manufacturing sector and mining investment that is now detracting from growth. Yet the RBA faces little or no criticism. There is no doubt that if official rates had started out at 6% in 2011, they would have fallen much faster and farther than they actually have done. It’s the actual level of nominal rates that people can’t get their heads around. Finally, the RBA has started making noises about macroprudential policies, or at least policies to require banks to lend on the basis of testing for an X% increase in rates. No one seems to recognise that the real risk is excessively tight policy, which leads to high unemployment and makes good loans bad. I think the Keynesian crap our economists and commentators have been taught for the last 60 years is to blame.
21. March 2014 at 23:09
Philo:
Not only is there is curious lack of curiosity regarding IOER, and how long that will last, nobody seems to care about the future disposition of the Fed’s balance sheet.
I contend the Fed should simply keep the $3 trillion hoard, freshening it up with new purchases as some bonds mature. That would make it a permanent increase in the national money supply, and it would also permanently deleverage federal taxpayers by a couple trillion. Not bad.
On IOER I think it would be interesting to start decreasing that by one basis point per months and see what happens. But I said the same thing one or two years ago….
No one seems to care about either topic.
Indeed, I think the number of people in the entire USA who really care about monetary policy must be under 5,000 (out of a population of 300 million plus).
Of that 5,000, maybe 1,000 are Market Monetarists, and of that 1,000 perhaps a few care about IOER and the disposition of the Fed’s balance sheet.
I may quit this whole field, and become a gardener, btw.
What’s the point?
22. March 2014 at 04:55
Mark, Krugman has a blind spot for other mechanisms, like exchange rate depreciation.
Thanks Lorenzo and Rajat, interesting analysis of Australia.
22. March 2014 at 22:43
Rajat: that makes sense to me. People talk the theory, but they do what seems to work.
(I expanded my above comments in a post:
http://lorenzo-thinkingoutaloud.blogspot.com.au/2014/03/the-virtue-of-pragmatic-central-bank.html )
23. March 2014 at 05:30
Lorenzo, Excellent post.
24. March 2014 at 08:41
Great post. I don’t think there is a corrupt conspiracy at the Fed. However, I do think there is a natural constituency with a hard-money bias (debt-holders) who are not afraid to talk their book and unfortunately have influence. Combine this with a lack of understanding and economic sophistication in the media, and you end up with a one-sided debate. There is a natural constituency in favor of higher inflation (ie. debtors) but they have no voice in the policy debate, because they are less informed, less organized and are morally stigmatized.
24. March 2014 at 11:56
The main problem seems to be that the Fed, despite all evidence, sincerely believes QE is inflationary.
Either that, or they think liquidity injections have some noninflationary benefit, which is probably worse.