Tag Archives: inflation target

Yellen at the Economic Club of NY

In Janet Yellen’s speech to the Economic Club of New York on Wednesday, she assured investors that low interest rates would continue and also focused on low inflation and economic slack. This was a follow-up to her meeting in March that left investors with the impression that interest rates would rise in the near future.

During the speech, Ms. Yellen made sure to point out that the economy is an uncertain place, and the Fed cannot lose sight of this as they propose monetary policy. However, she did give a more concrete prediction of when she expects to rise rates. She intends to keep interest rates low until at least the middle of 2015, given that the economic outlook allows the US to maintain low interest rates.

Another main point that Yellen stressed was the inflation rate target. She said that she was more worried about inflation becoming too low rather than too high. Later she added that the Fed’s focus should be on lifting inflation to the 2% target, not holding it down. During the speech, she commented, “The Fed is “well aware” that inflation could shoot above its 2% goal, she said. ‘At present, I rate the chances of this happening as significantly below the chances of inflation persisting below 2%.’” Low inflation is a problem because it signals weak economic demand. Also, not leaving a large enough inflation threshold can lead to deflationary problems in the future. Deflation is detrimental to the economy because it leads to many painful outcomes- the combination of falling prices, consumers’ reduced likelihood of spending, and falling wages depresses the economy and sets it into a deflationary trap. This triggers a vicious circle because rising debt leads to less spending, which leads to further deflation… and repeat.

The problem comes into play when the Fed tries to dictate certain economic issues like long-term unemployment and income inequality. The Fed mentioned that it would like to see wage inflation because this would indicate that slack in the labor market is starting to disappear. Hence, they don’t want discouraged workers to get dropped out of the labor force permanently. Decreasing slack in the labor market will later get job creation back on track. However, the problem is that it’s hard for the central bank to influence these policies. At the end of the day, the central bank is chartered by congress as an independent agency within the government- not to be a policymaker itself. I think that in terms of the trade off between inflation and unemployment, the Fed has more control on the economy through dictating stable inflationary levels. As we have already seen, the Fed has abandoned the unemployment target because there are too broad of measures included that make up this target- many of which the Fed can only indirectly control, if at all. Although the two issues are interrelated- short-term unemployment is relevant for inflation, I believe that the Fed would get the most out of rising inflation back to the 2% target.

(Revised) Fed, Raise the Inflation Target

Originally posted on March 29th

Friday’s report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed’s target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its “target” for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called “target”? In my Monday’s post, I made a case for the second question getting an answer “yes!”. If the Fed is indeed targeting inflation rate lower than its 2 percent “target”, the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation “target” given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let’s look at the Fed’s latest statement:

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed, in my policy prescription, should change “run below the Committee’s 2 percent longer-run goal” to “run below 3 percent” (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn’t been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn’t seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson’s paper?

Fed, Raise the Inflation Target

Friday’s report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed’s target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its “target” for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called “target”. In my Monday’s post, I made a case for the second question getting an answer “yes!”. If the Fed is indeed targeting inflation rate lower than its 2 percent “target”, the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation “target” given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let’s look at the Fed’s latest statement:

“To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress–both realized and expected–toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.”

The Fed, in my policy prescription, should change “run below the Committee’s 2 percent longer-run goal” to “run below 3 percent” (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn’t been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn’t seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson’s paper?

Sorry Krugman, It Is Not Happening (or seems to be)

In his blog post on last Friday, Paul Krugman argues that the Fed should be targeting 4 percent inflation rate, which is, according to him, the inflation rate that is needed when the economy is at the zero lower bound, instead of current inflation target of 2 percent. He argues that by targeting inflation rate which is lower than a rate needed by the economy to get boost, the Fed does nothing to raise the inflation rate, which is currently below 2 percent, because even if the market believes in the Fed’s target of 2 percent inflation rate at the beginning, its inflation expectation will decrease as time goes and actual inflation will be back at the low level. But, according to him, if the Fed explicitly targets 4 percent inflation rate, assuming 4 percent inflation is the right amount to boost the economy, this will give boost to the economy and hence drives the inflation up. However, the Fed is not even considering to target above 2 percent inflation rate as opposed to Krugman’s inflation target of somewhere around 4 percent. We can see an evidence for the Fed being hawkish.

In the Fed’s recent statement, it dropped infamous 6.5 percent unemployment threshold for raising short-term interest rate. Known as the Evans rule, the Fed’s former quantitative forward guidance statement was giving timeline for raising interest rate closely tied to the unemployment rate. As we know, once the unemployment rate unexpectedly (for the Fed) dropped to 6.6 percent in last month, it had to change its forward guidance program because if it had continued mentioning 6.5 percent threshold, and once the unemployment rate had reached the threshold, the Fed could have then made market expectation of increasing short-term interest rate when the economy needed the opposite. To avoid this unexpected mistake, they dropped the quantitative threshold for raising the interest rate.

The Fed undoubtedly has learned its lesson: Never underestimate the economy or should I say power of some number like 6.5? Having experienced the problem of changing the forward guidance appropriately, the Fed must have now issued their statement with great care of not choosing any random numerical threshold. But guess what? The Fed’s statement still includes the inflation target of 2 percent. The Fed’s latest statement reads:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee’s 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Let’s now imagine that somehow the inflation rate reaches around 1.9 percent in one of the coming months and assume the economy will not have gotten out of the recession slack (which is very likely), the Fed now faces the same problem it faced two months ago when the unemployment rate almost hit 6.5 percent threshold, but, in this case, only the inflation rate almost hits the target of 2 percent. Should then the Fed increase the federal funds rate according to its statement inferred if the inflation rate reaches 2 percent target? or should the Fed change its forward guidance again and drop the inflation rate target as it did unemployment rate threshold? Interestingly, the Fed will do neither of them because:

First, they learned its lesson of changing the guidance prematurely. Second, and more importantly, they KNOW that they will never face the inflation rate close to 2 percent during the recovery; hence, they won’t have to do either of above.

In other words, from the Fed’s current statement and its current mistake, we can almost be sure that it will never target the inflation rate above 2 percent as long as the economy is still recovering. Two percent inflation target is then an upper bound for the inflation rate the Fed targets.

Some people has argued even that the upper limit of 2 percent for the inflation target is indeed what the Fed has been pursuing for these years.

Therefore, it seems unlikely that Krugman will see whether 4 percent inflation target could get the economy back to work. Sorry Krugman, it is not happening (or seems to be).