Two FOMC voting members are likely to ‘lock horns’

In my most recent post I dealt with Plosser´s views:

Thus, I continue to believe that the U.S. economy is on a firmer footing today than it has been in several years. This is a cause for some optimism for continued progress in 2014. My forecast has been for growth of about 3 percent in 2014, and while the weather-related softness in the first quarter may temper this full-year outlook somewhat, it hasn’t led me to downgrade my outlook for the remainder of the year.

The FOMC also noted, based on its assessment of these factors, that it likely will be appropriate to keep its target federal funds rate near zero for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the 2 percent goal and longer-term inflation expectations remain well anchored. My own view is that, as we continue to move closer to our 2 percent inflation goal and the labor market improves, we must be prepared to adjust policy appropriately. That may well require us to begin raising interest rates sooner rather than later.

Narayana Kocherlakota thinks differently:

(Reuters) – U.S. inflation may not climb back to 2 percent until 2018, so the Federal Reserve should consider overshooting that target for a few years afterward to make up for the current period of low prices, a top Fed policymaker said on Wednesday.

Narayana Kocherlakota, president of the Minneapolis Fed, floated the idea of “price level targeting” but did not explicitly endorse it, saying in a speech the idea deserves “serious discussion” at the U.S. central bank.

Under price level targeting, the Fed would let inflation run above its 2-percent goal in the years ahead to make up for the currently low prices for goods in the economy. As it stands, the Fed practices “inflation targeting” in which it aims for the goal at all times irrespective of past trends.

Kocherlakota said price targeting would make long-term contracts safer for both borrowers and lenders, since inflation would average closer to 2 percent over years. And, he said, it would serve as an automatic stabilizer for the economy.

But, as the reporter notes:

Most of the world’s central banks target inflation and not prices, for fear of letting inflation get too hot [causing the Plosser´s of this world to suffer a heart attack].

Let me set the ‘stage’. The charts begin in 1992 because that´s when Greenspan used the 1990/91 recession to bring inflation to a more ‘desirable’ level, where ‘desirable’ meant an inflation level that didn´t ‘bother’ people.

From then until about 2007 no one can say exactly what the Fed was ‘targeting’. The Fed didn´t have an explicit target but the common view was that it ‘targeted’ inflation at something close to 2%. But one could equivalently deduce that the Fed was targeting the price level (Headline or Core), or even that it engaged in NGDP level targeting.

Lock horns_1

Average headline inflation over the 1992-14 period is 1.9% (that´s the trend rate of PCE headline price level growth); average core inflation is 1.8% (the trend rate PCE-Core prices increase) and average NGDP trend growth is 5.4%

It appears from the charts that headline inflation is too ‘noisy’ (buffeted by oil and commodity price fluctuations), and it seems that the Greenspan Fed mostly avoided worrying with that. But remember that in July 2008 Plosser, likely reflecting the view of the majority (as gleaned from the 2008 Transcripts) said:

Since energy price increases have been so persistent in recent years, I do believe more attention should now be paid to measures of headline inflation in setting monetary policy. I don´t believe we can be sanguine that the behavior of core inflation will keep the public’s inflation expectations well-anchored in the face of persistently high headline inflation. To keep inflation expectations anchored means that monetary policymakers will have to back up their words with action.

Note from the chart above that ‘full attention’ to headline inflation was tantamount to tightening monetary policy, measured by NGDP, or aggregate nominal spending, falling below trend and then ‘tanking’.

To borrow an image from Nick Rowe, what we observe while going into 2008 was that the inflation and price level ‘dogs’ were ‘barking at the wrong tree’ (the one indicating the economy was overheating), while the NGDP level target ‘dog’ was ‘barking at the right tree’ (the one indicating the economy was sliding downhill).

Why was that so? Because in the case of price (or supply) shocks, inflation (or the price level) increases while real output falls. If the Fed tries to bring inflation (or the price level) down to target, this will magnify the impact of the original shock on output. In this case the first-best solution is to keep aggregate nominal spending growing at the trend rate (i.e. target the level of NGDP), thus minimizing the recessionary effects of the shock..

The charts below ‘zoom in’ on the last 10 years.

Lock horns_2

Note that during the last few years of Greenspan´s tenure oil and commodity shocks increased headline inflation and pushed the PCE headline price level above trend. The Fed didn´t try to counteract those shocks, but kept nominal spending growing on the ‘target’ path. The persistence of the shocks ended up having a small effect on core prices and core inflation after Bernanke took over in January 2006 and soon the Fed began to tighten the ‘monetary screws’ as indicated by nominal spending sliding down below the trend path. When oil prices increased further in 2007-08, the Fed ‘despaired’ and a huge spending contraction  (the largest since 1938) ensued.

The next chart shows the short run (1 year) and the long run (10 year) inflation expectations (from the Cleveland Fed). Note the ‘jumpy’ behavior of short run expectations, mostly reflecting the volatility of oil and commodity prices. But long term expectations remain contained and relatively stable throughout those critical years. The Greenspan Fed didn´t flinch while Bernanke´s Fed went on a ‘monetary tightening spree’ (which is quite independent of the level of interest rates).

Lock horns_3

It would be better if Kocherlakota had proposed an NGDP level target. To hear the Fed ‘talking about higher inflation’ is blasphemous. The reporter´s addendum is quite correct.

In fact, the Fed has rehearsed introducing a NGDP level targeting proxy. QE 1 and QE 2 were basically anti-deflation mechanisms, having been introduced when both inflation and inflation expectations were falling to ‘dangerously low levels’. But QE 3 came along with ‘thresholds’ (inflation and unemployment) attached, while still using the interest rate ‘language’. It hasn´t worked very well and has caused confusion. The only ‘threshold’ the Fed should announce is an NGDP level target, and ‘shoot for it’.

4 thoughts on “Two FOMC voting members are likely to ‘lock horns’

  1. In your charts you often supply a “trend” line, for comparison with the actual magnitude over time. How do you determine these trend lines? Most of them look quite arbitrary.

    • Philo, the trend lines are estimated by regression. What I usually do is estimate the trend for the GM period, to 2005 or 06 and then project forward. The estimated trend line for PCE, for example, gets a trend line of 1.94%, for all practical purposes, therefore, the Fed succeeded in ‘targeting both the price level and the rate of inflation at 2%!

  2. I take it the GM period runs from 1982 (1983? 1984?) to 2005 or 2006 (why not 2007?), and your reason for treating this period’s trend-lines as normative is that this is precisely the recent period of good monetary policy in the U.S., which shows us what the economy is capable of under an appropriate monetary regime.

  3. Excellent post.

    This reminds me a bit that Fed Chairman Arthur Burns over-accommodated oil shocks in his day, but did manage to keep the economy growing despite huge oil shocks–back when the economy really was dependent on “cheap oil.”

    The record is clear, Burns was “too easy,” but he had his points.

    Today, the Fed manages to asphyxiate the economy despite much smaller and less important oil shocks, and inflation rate that has been rather tame anyway.

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