Fed Watch: A Missing Ingredient

Tim Duy:

A Missing Ingredient, by Tim Duy: Ryan Avent makes a good point about San Francisco Federal Reserve President John Williams' recent FT interview.

Avent is less impressed than me on Williams' conversion to open-ended QE as a policy tool because it by itself does not communicate a willingness to allow inflation to exceed 2%. I think that Avent is on the right path. While Williams did make what I think is a big step, he could go one step further and not only call for open-ended QE, but to do so in the context of Chicago President Charles Evans' suggestion for explicitly tolerating inflation up to 3%. That said, I also think this is too much to hope for, as I haven't seen any indication that Williams would be willing to deviate from the 2% target.

Also, you can interpret open-ended QE as a higher possibility that the Federal Reserve will not be able to pull-back the increase in the money supply, thus one could expect higher inflation in the future. And by leaving the program as open-ended, you remove the uncertainty created by arbitrary end dates and purchase amounts. So I do think that Williams is making a significant shift in the right direction. But I agree with Avent that a clear communication of tolerance for higher inflation would be even more effective.

Ultimately, I think the Federal Reserve made a huge policy error in committing to an explicit 2% inflation target. I think policymakers were under the impression that such a commitment would give them more flexibility by removing concerns that QE would be inflationary. In reality, I think it had the opposite effect - it eliminated a policy tool, thereby reducing their flexibility. And that commitment stands as a barrier to Evans' suggested policy path. I think the rest of the Fed would loathe accepting inflation as high as 3% given they just committed to 2% at the beginning of this year. In doubt, they would view such backtracking as a threat to their much-cherished credibility.

Interestingly, they don't see Treasury rates below 1.4% as a threat to their credibility. They really should.

Here's what I said on this topic a few months ago:

...why does the Fed put so much value on its credibility?

An abundance of credibility allows the Fed to bring the inflation rate down from, for example, 5 percent to 2 percent at minimal cost to the economy. It also makes it less likely that inflation will become a problem in the first place, because high credibility makes long-run inflation expectations less sensitive to temporary spells of inflation. So maintaining high credibility has substantial benefits.

Does this mean the Fed should do its best to keep the inflation rate at 2 percent?

Sticking to a 2 percent target independent of circumstances is not optimal. There are times, such as now, when allowing the inflation rate to drift above target would help the economy. Higher inflation during a recession encourages consumers and businesses to spend cash instead of sitting on it, it reduces the burden of pre-existing debt, and it can have favorable effects on our trade with other countries.  

If inflation begins to rise before the recovery is complete the Fed could, for example, announce that it is willing to allow the inflation rate to stay above target temporarily in the interest of helping the economy. But once unemployment hits a pre-set rate, for example 6.25 percent, or core inflation rises above some predetermined threshold, for example, 5 percent, then, and only then, will the Fed step in and take action. ...

So no disagreement here, except that I would set the limit even higher than 3 percent inflation since I am not at all worried about the Fed's long-run credibility on inflation. As I noted, "I have no doubt that, once the economy has finally recovered, the Fed will ensure that the inflation rate is near its target value, so long-run credibility is not at risk."

One further note: I have asked Federal Reserve officials directly why the 2% inflation target is treated as a ceiling rather than a central value, and have been assured that it is, in fact, a central value (so that inflation should fluctuate around the target value instead of staying at or below target as it would if the target is a ceiling). But the data suggests otherwise -- the errors have been mostly one-sided (i.e. inflation has generally been below target). Even if the Fed is unwilling to raise the target, it should at least tolerate enough of a rise in the inflation rate to get two-sided errors, but it hasn't even been willing to do that.