Ryan Avent at the Economist Free Exchange takes us on a “loony trip”. It´s all about the “correct” interpretation of the latest FOMC statement:
ON FRIDAY, Brad DeLong blogged a slide from a Christina and David Romer lecture on practical monetary policy at the zero lower bound. The slide contains the Fed’s language on low rates from the latest statement and then adds:
So let’s back up. At the zero lower bound, the only way to reduce the policy rate is to raise expected inflation. The Fed’s communication strategy seems designed to raise expected inflation, by promising to keep rates low in the future when the economy will probably be stronger. To the extent that markets interpret the statement in that way, inflation expectations should rise, the real interest rate should fall, and economic activity should accelerate.
But, as the text in the slide indicates, a strict reading of the Fed statement suggests that the central bank is planning to keep rates low because the economy is likely to remain weak. In that case, the rate forecast wouldn’t be expected to raise inflation and wouldn’t be stimulative. I shy away from the strict interpretation of the statement, because it would make no sense to add the language in the first place if that’s what the Fed were actually saying. Perhaps too charitably, I lean toward a view that the Fedis trying to raise inflation expectations without spooking its critics, internal and external.
And goes on:
Unless the Fed continues with its enhanced communications strategy up to the point at which communications are actually enhanced, we’ll all be left wondering about the meaning of the statement until the point at which the Fed is forced to show its hand. Unfortunately, oil-price dynamics may interfere.
What happens then?
The trouble, as Mr Duy points out, is that an increase in short-term inflation due to rising commodity prices does not necessarily translate into lower real interest rates. It is expected inflation that matters, and inflation expectations may actually fall in response to higher commodity prices. A fun intellectual discussion might be to try and pick apart whether the drop in future expectations is due to the contractionary nature of dear oil or the central-bank response or something else. Whatever the cause, the upshot is that a rise in commodity prices which pushes up headline inflation but reduces medium-term inflation expectations is strictly contractionary at the zero lower bound.
The right monetary policy reaction is not only to accommodate the oil shock but to ease into it. That will unquestionably be a hard sell to a central bank that understands all too well the lack of appreciation for the subtleties of monetary policy in Congress (and, honestly, at the top of many regional reserve banks). Try telling Ron Paul that you need to buy more assets to raise inflation, because higher oil-induced inflation is reducing expectated inflation. That’s where America may find itself, however. In short, a big enough rise in oil prices that translates into a big enough decline in expected growth and inflation may nudge the Fed from the rates-will-be-low-because-we-want-catch-up-growth interpretation toward the rates-will-be-low-because-the-economy-will-be-weak interpretation. Which would dial down the stimulative impact of the language from something to nothing.
At the end we avoid being locked-up in the “loony bin”:
It’s enough to get one thinking that a non-inflation-rate target (like nominal GDP, for instance) might be more attractive from both an economic and a political economy standpoint. Perhaps unsurprisingly, Mrs Romer is on board.