The Fed has been in this dilemma before and the results were not good!

From the WSJ:

Falling gasoline prices may be tough for those who own filling stations or are otherwise involved in the energy business, but they’re good for consumers. Money households don’t have to spend on fuel is money that can be spent on other goods and services, which in turn can help boost growth.

The inflation front is where things get trickier. Falling gasoline prices also pull down headline inflation. Normally, that’s welcome. But now? Not so much.

Price pressures have ebbed to a degree that inflation, as measured by the Fed’s favored personal consumption expenditures price index, is trending well under the Fed’s 2% target. Year over year, this measure was up 1% as of March.

As the decline in energy prices winds its way through the data, it’s likely headline inflation will cool even more. That puts the Fed in a challenging position: many officials have placed equal importance in defending the 2% from both the high and low side.

Based on that, the farther inflation moves under the Fed’s 2% target, the greater the theoretical urgency officials face to make an already very easy stance of monetary policy even more aggressively stimulative. So far, while some officials like James Bullard at the St. Louis Fed have opened the door to acting should inflation trend even lower; most officials still think the economy is improving enough to slow down the current pace of bond-buying stimulus later in the year.

This is just another example showing how misleading (even dangerous) inflation targeting can be. And they have the gall to think monetary policy is “very easy and could have to be made even more aggressively stimulative”.

Let´s take a look at some recent history. And this is illustrated by a set of charts on inflation (both headline and core) and the NGDP Gap (the distance of NGDP from its great moderation ‘trend’ level).

In the second half of the 1990s productivity growth shot up. There was also a big drop in oil prices following the Asia crisis. Inflation came down and real growth increased (as should be expected). In mid-1998 the Russia crisis and the LTCM fallout may have ‘tricked’ the Greenspan Fed into being ‘overly’ stimulative. NGDP climbs above trend.


In the follow-up, the Fed tightened excessively. NGDP fell well below trend. Headline inflation went too low. This was the time Bernanke spoke on “Deflation, making sure ‘it’ doesn´t happen here”. Rates were brought all the way to 1% but the economy ‘refused’ to react.


In the next stage, the Fed adopted forward guidance, succeeding in ‘pushing’ NGDP uphill towards the trend level. An oil price shock intervened but Greenspan kept his ‘cool’, mumbling about “appropriate monetary policy” to calm down the Fed watchers.


This is followed by Bernanke´s ‘disaster’. Worrying too much about headline inflation resulting from the second leg of the oil price shock the Fed succeeds in letting NGDP keep falling short of trend before tumbling into the ‘abyss’.


The Fed should have learned from this varied experience that what matters is to keep NGDP on the stable trend level path and never mind oil prices (another instance of “never reason from a price change”)

But apparently not. The last set of charts shows how deep inside the hole spending is (so it´s not surprising real growth is anemic and employment is lacking). Even if you argue that the Great Recession has strongly reduced the trend level path, there is still a lot of ‘slack’.


What the Fed should do was set its sights on the ‘new’ trend level and define that as the economy´s destination with an ETA established beforehand so progress could be easily monitored.

Unfortunately many seem to be ‘locked’ into the symmetric inflation targeting mode of thinking. And that´s very dangerous at this point in time.

One thought on “The Fed has been in this dilemma before and the results were not good!

  1. Pingback: Lower (supply) inflation is NOT a reason to ease US monetary policy | The Market Monetarist

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