Brief Outline of Topics Covered in Lecture 15
Chapter 24 Money and Inflation
- Debt monetization
- The activist/non-activist debate
- Policy lags and other problems in pursuing activist policies
Chapter 25 Rational Expectations and Implications for Policy
- RE and the Lucas critique
Materials from class:
None for today
Video:
Lecture 15 - Chapter 24, pgs. 626-635; Chapter 25, 639-641
Google Video
Additional Reading:
A Sad Day
Milton Friedman: Why Money Matters
Will Globalization Cause Currency Unification?
FRBSF: Interest Rates, Carry Trades, and Exchange Rate Movements
NBER Reporter: Firms in International Trade
Is Monetarism Dead?
Application:
Fed Far From Inflation-Target Policy, by John M. Berry, Bloomberg: After much study and discussion, Federal Reserve officials are far from adopting inflation targeting as part of the monetary policymaking process.
And even though Fed Chairman Ben S. Bernanke favors having some sort of explicit target, the outcome of the comprehensive review of the concept he set in motion remains unclear.
A substantial portion of the Oct. 24-25 meeting of the Federal Open Market Committee was devoted to communications issues and discussion of ''the advantages and disadvantages of quantifying an inflation objective,'' minutes of the meeting released Nov. 14 said.
Even proponents of the idea have agreed the advantages wouldn't be great, and there are plenty of disadvantages. The minutes didn't list any of either. They said only that ''the possible specification of a numerical price objective raised a number of complex and interrelated issues that required considerable further discussion.''
The 18 FOMC participants had no trouble reaffirming their acceptance of the Fed's legal mandate to achieve maximum employment and moderate long-term interest, as well as stable prices. They also reiterated the long-held Fed view that achievement of stable prices is a prerequisite for meeting the other goals.
The officials will pick up where they left off at the committee's next two-day meeting in late January.
Not Simple
On the surface, having an inflation target seems a simple matter. After all, almost two dozen central banks around the world have one. On the other hand, the Fed achieved what officials regarded as price stability without an explicit inflation target.
Economist Bill Dudley of Goldman Sachs Group Inc., who has followed Fed policy for years, said in an interview on Nov. 16 that incorporating an inflation target into the Fed's policymaking process is anything but simple.
If the Fed were to announce a target -- mostly likely a range rather than a single number -- what would the time frame be to reach it?, Dudley asked.
''There is no right answer, and the longer it takes, the greater the risk to the Fed's credibility,'' Dudley said.
By that, he meant that financial markets might ''over- weight'' what the Fed is indicating in setting the target, concluding that the central bank will seek to meet the target under any and all circumstances. The economy may not cooperate and the target might remain well out of reach due to unforeseen events, particularly within a set time frame, he said.
Getting There
''The Fed is a more fallible place than the market thinks, through no fault of the Fed's,'' Dudley said.
If the Fed announces an explicit inflation target, the natural next question is, how does it get there?
''Okay, you say you are going to achieve X, Y and Z. Then what is your monetary policy?'' Dudley asked.
That's a question many Fed officials are asking themselves right now, and not because they have an explicit inflation target. The FOMC stopped raising its separate target for the overnight lending rate once it was raised to 5.25 percent in June.
Nevertheless, officials generally are projecting a gradual decline in core inflation to below 2 percent over the next couple of years. It was 2.4 percent in the 12 months ended in September according to the Fed's preferred measure.
Understanding Inflation
Yet numerous Fed officials, including Vice Chairman Donald L. Kohn, have said publicly that they aren't sure that forecast will be realized because they aren't confident they know how the inflation process works in the U.S. these days.
In an Oct. 4 speech, Kohn said the central bank needs to be vigilant about ''upside risks to the outlook for inflation,'' in part, ''because our understanding of the inflation process is limited.''
Core inflation accelerated last spring and summer for reasons that aren't really clear, Kohn said, adding, ''I would feel much more confident about where we are heading if I had a more accurate bearing on the direction from whence we have come.''
Kohn has been a persistent opponent of setting an inflation target. Perhaps to insure that the current discussion of targeting is a genuinely thorough examination of the issues without a preordained outcome, Bernanke put Kohn in charge of the FOMC task force guiding the debate.
'Comfort Zone'
Some Fed officials must be thinking about inflation targeting in the context of the current situation. Many of them, including Bernanke, have said their ''comfort zone'' is an inflation rate of 1 percent to 2 percent.
Two of the issues in the debate are what inflation measure should be targeted and what the acceptable range should be. Few among the general public even know what the core personal consumption expenditure price index is, yet that is the measure of inflation Fed officials watch most closely rather than the much more well-known consumer price index.
And what should the target be? In 2003, then-Fed Chairman Alan Greenspan and Bernanke, a member of the Fed Board, became very concerned when core inflation fell to about 1 percent, fearing an episode of deflation -- a broad decline in the price level that could damage the economy.
So is 1 percent to 2 percent the right range? Would 1.5 percent to 2.5 percent make more sense? What would investors think if the Fed adopted such a higher target range if core inflation were still above 2 percent?
That's another complexity, said economist Peter Hooper of Deutsche Bank: ''There's no way they're going to move the goal line before they score a touchdown.''