Tim Duy's latest Fed Watch discusses inflation targeting and how much further the target federal funds rate will be increased:
I have read my fair share of Federal Reserve Speeches over the years, and I am accustomed to hearing hawkish sounding rhetoric to the effect of Chicago Fed President Michael Moskow in a speech last week:
Still, given that the economy is operating close to potential, we need to be careful to monitor for the emergence of any economy-wide strains on resource utilization. Such strains would have the potential to increase inflationary pressures.
Or St. Louis Fed President William Poole in a Reuter’s interview:
My sense is there is a great deal of momentum in the economy. I don't think that it is momentum of the sort that is going to run us off the rails
But every once in awhile, a something new comes along. I thought I noticed something when I first wrote about a speech by Richmond Fed President Lacker, when he said:
“Unpredicted movements in economic fundamentals, to the extent that they affect the relative pressure on current and future resources, thus will have implications for policy rates, even in situations in which inflation and inflation expectations are low and well-contained.”
This was the first time I can recall a policymaker referring to policy in terms of “current versus future resources,” although a quick look at Lacker’s previous speeches revealed that I just had not been paying close enough attention (my excuse: I have to do the job the University pays for first). Lacker expanded on this theme in a February 14 speech:
“For how does one conduct monetary policy when inflation is low and stable? Here we can draw on our understanding from a class of models that researchers have developed and studied in the last decade or two. While this research program is still in progress and important open questions remain, a few clear principles have emerged. First, holding interest rates steady until inflation or deflation pressures are actually visible is clearly inappropriate. Instead, policy should be conducted recognizing that real interest rates should be expected to fluctuate with economic conditions. A real interest rate is the relative price of current resources in terms of future resources. It represents the real amount of goods and services one must sacrifice in the future (in addition to the repayment of principal) to obtain real goods and services today. As I have emphasized elsewhere, real interest rates should be expected to fluctuate over time in response to variations in the relative pressure on current versus future resources.2 When current resource demand is less than it will be in the near future — as was the case from 2001 through the beginning of 2004 — then real interest rates need to be low to reflect the relative lack of pressure on current resources. When that relative pressure on current resources rises, as has been happening over the last two years, then real interest rates need to rise. In such circumstances, if the Fed sets and keeps the funds rate too low, the inevitable result will be rising inflation.”
Note that he does not talk directly about resource utilization, inflation expectations, unemployment, or any of the usual trademark indicators of monetary policy. This is deliberate – these are concepts that make you think of visible inflation pressures. But he clearly states at the beginning of this paragraph that policy cannot wait until visible inflation pressures emerge. Instead, Lacker talks of relative pressure on current versus future resources. He even gives an example:
“I emphasized that real, inflation-adjusted interest rates should be expected to fluctuate in such circumstances, even in the absence of visible fluctuations in inflation pressures. With inflation low and steady, changes in real interest rates require changes in the nominal overnight policy rate that the Fed directly controls. Communicating that fact will help the public understand that policy needs to respond to changing real economic conditions. Moreover, focusing on real interest rates draws attention to how and why policy must respond; real interest rates must fluctuate to accommodate changes in the relative pressure on current versus future resources. Widespread understanding of this would have aided the market response to Katrina; the storm impaired the supply of current resources relative to the future, and so, if anything real interest rates had to rise, not fall.”
This, interestingly, says that the Fed had not correctly communicated its underlying policy, causing confusion over the likely course of policy following Hurricane Katrina.
Lacker is the only policymaker I knew who is describing policy in the fashion. The only, that is, before I gave New York Fed President Tim Geithner’s March 9 speech a close read. And low and behold:
“What might this mean for the conduct of monetary policy? To the extent that these forces act to put downward pressure on interest rates and upward pressure on other asset prices, they would contribute to more expansionary financial conditions than would otherwise be the case. And, if all else were equal, which of course is unlikely ever to be the case, monetary policy in the affected countries would have to adjust in response; policy would have to act to offset these effects in order to achieve the same impact on the future path of demand and inflation. To do otherwise would run the risk that monetary policy would be too accommodative, pulling resources from the future in a way that would alter the trajectory for the growth of the capital stock, perhaps amplifying the imbalances, and compromising the price stability.”
Many have noted that this speech is a variation of Geithner’s January 23 speech. The “pulling resources from the future” language is new.
Why exactly am I so intrigued by this approach? Well, compare it to Minneapolis Fed President Gary Stern in his comments to Market Watch:
As good a way as we have to forecast inflation ... for the next 12 months is whatever it's been over the past 12 months," he said. "That is not entirely satisfactory, but there is a danger if you take a different approach," he said.
Now, I don’t want to be unfair to Stern on the basis of one interview, but taken at face value, the Lacker language is levels of sophistication above the Stern language. Perhaps they are all working off the same basic model in the background; then Lacker and Geithner are simply implementing a more sophisticated communication strategy. Ask yourself this: Who do you have more confidence in setting an explicit inflation target? The policymaker who claims that your best forecast of inflation is the lagged inflation rate? Or the policymaker who claims that by the time you see inflation (or deflation), you have already messed up?
The answer, I think, is obvious. The Lacker language deemphasizes current and past inflation. It avoids the language of “resource overutilization,” a euphemism for “low unemployment.” It is a forward looking description of policy. It emphasizes the need for policy to respond in the absence of visible inflation pressures. The last is particularly important; implemented properly, the inflation rate would be essentially a flat line, uncorrelated with movements in the Fed Funds rates. In other words, you do not (and should not) have to see inflation moving outside your target to change the path of policy.
In short, the language is an attempt to lose some of the baggage of past monetary policy that would render an explicit inflation target difficult to implement. The Stern comments, for example, provide ample fodder for critics of inflation targeting. It suggests that inflation target will be a classic case of “driving by the rearview mirror,” and keeping your eyes on a lagging variable, no less!
For the record, as of October 25, 2005 at least (thank you David Altig), Lacker and Stern had revealed a preference for inflation targeting. At that point, Geithner had made no public comments. John Berry claimed that Geithner would be opposed to inflation targeting. Is Geithner’s adoption of the Lacker language a move in the direction of inflation targeting? Or is it just a coincidence?
On Monday, San Francisco Fed President Janet Yellen, already an inflation targeting proponent, suggested an explicit target of 1.5% on core PCE, with a 1-2% comfort zone. Yellen is the first to offer something more specific than a range. She also notes that inflation targeting does not necessarily reduce the importance of the Fed’s full-employment mandate, addressing another criticism of targets.
Operationally, I am not convinced that an explicit inflation target will have much of an impact on policy. In my opinion, the Fed already is implicitly setting an inflation target in the range of 1-2%, and have done just about everything short of explicitly providing a numerical target. Moreover, setting an inflation target does not eliminate the hard work of policymaking. It does not mean “if inflation is greater than 2%, then raise rates until it is less than 2%.” Policymakers still need to determine the “relative pressure on current versus future resources.” And that means reading the tea leaves and forecasting the likely path of economic activity – an exercise that will lead to varying opinions. For example, in contrast to Stern’s hawkishness, Yellen sounded downright dovish in her comments to reporters. From MarketWatch:
In comments to reporters after her speech, Yellen said that Fed policymakers must be aware of the risk of overheating. "We are in a range where Fed decisions have become quite data dependent and there needs to be sensitivity to the possibility of overshooting," Yellen said. Yellen said the economy was in good shape, but growth would taper off later this year. Yellen said she did not see wage pressures threatening inflation. "We do see continued robustness in the labor market, but that is not a surprise," Yellen said. "I don't see wage pressures there yet threatening price stability," Yellen said.
Like Stern, she sounds ready to pause sooner than later – the dovish faction is likely gaining some ground in the FOMC. Given current economic conditions, expectations of slowing in the back half of this year, and the degree of tightening already in the pipeline, I am having trouble seeing the Fed move beyond 5%.
Update: John M. Berry says Bet on the Fed to Pause at 5 Percent, Not 5.5.