As we explained over two months ago, and as the Fed is no doubt contemplating currently, the primary topic on the agenda of central bankers everywhere and certainly in the Marriner Eccles building, is how to boost inflation expectations as much as possible, preferably without doing a thing and merely jawboning “forward expectations” (or more explicitly through the much discussed nominal GDP targeting) in order to slowly but surely or very rapidly and even more surely, get to the core problem facing the developed world: an untenable mountain of debt, and specifically, inflating it away. Of course, higher rates without a concurrent pick up in economic activity means a stock market tumble, both in developed and emerging countries, as the Taper experiment over the summer showed so vividly, which in turn would crush what many agree is the Fed’s only achievement over the past 5 years – creating and nurturing the “wealth effect” resulting from record high asset prices, which provides lubrication for financial conditions and permits the proper functioning of capital markets. Perhaps this is the main concern voiced by JPM’s chief US economist Michael Feroli who today has issued an interesting piece titled simply enough: “Raising inflation expectations: a bad idea.” Is this the first shot across the bow of a Fed which may announce its first taper as soon as two weeks from today, in order to gradually start pushing inflation expectations higher?
And if so, it provides an interesting perspective of where on the reflation debate the big banks – easily the biggest beneficiaries of the Fed’s ultra loose policies – and specifically JPM, whose $550 billion in excess deposits exist only thanks to QE, will stand once the Fed shifts from ultra easy to, well, less than ultra easy mode.
Said otherwise, are the TBTF megabanks about to fight the Fed?
Full note from JPM’s Michael Feroli below:
Raising inflation expectations: a bad idea
Ever since the Great Recession there have been repeated calls for the Fed to raise its inflation target, thereby increasing inflation expectations and hopefully speeding the recovery. We have viewed this strategy as ill-advised. Encouragingly, two separate strands of research give support to our view, and make us more confident that the Fed will not go down this path. It is important to emphasize that our thinking and the thinking contained in the Fed research does not oppose a higher inflation target simply out of distaste for higher inflation, but instead because a higher inflation target could have some immediate adverse consequences for growth and employment. We also note that this critique applies not only to policy measures that directly raise the inflation target, but also to ones that could do so through the “back door,” such as nominal GDP targeting.
The case for
The argument for higher inflation expectations takes a few forms. The most conventional such argument stresses the fact that higher inflation expectations will lower real interest rates. Recall that nominal interest rates equal real interest rates plus expected inflation. If nominal interest rates are unchanged, then a rise in inflation expectations serves to reduce real interest rates. Since real interest rates are believed to be what matters for economic activity, lower real interest rates imply more investment spending, greater home sales, and so on. When short-term nominal interest rates are already at zero and thus constrained from falling any further, the improvement that can be engineered by raising inflation expectations – and lowering real interest rates – is particularly appealing, as it appears to be one of the few ways that central banks can further stimulate the economy without relying on fiscal coordination.
The case against
If the world we lived in were the world of textbook economics, then raising inflation expectations would quickly get the economy back to full employment. Unfortunately the world is not that simple. One simple complication is the fact that if you are reading this note you probably already follow the Federal Reserve more than the average person. Former Fed Vice Chair Frederick Schultz remarked in 1979 that “most people thought the Federal Reserve was either a bonded bourbon or a branch of the National Guard.” While public awareness of the Fed has increased since then, Main Street businesses and consumers still probably pay little attention to Fed edicts, whereas financial market participants are likely to read FOMC statements, to know that Yellen is a dove, Plosser a hawk, and to understand that the Fed’s long-run inflation goal is 2 percent.
These market participants are likely to immediately react to any hint that the Fed is raising its inflation target, and the reaction would come in the form of higher long-term nominal interest rates, as lenders would demand a higher premium for inflation compensation. Since Main Street businesses and households are less prone to hang on the Fed’s every word, their inflation expectations will be less affected by FOMC pronouncements, and a rise in nominal interest rates would be seen as a rise in real interest rates. Thus, raising the inflation target would increase nominal interest rates, and with inflation expectations outside of the financial sector essentially unchanged, this would mean higher real interest rates and a slower recovery.
A recent research paper produced by senior Federal Reserve staff received considerable financial market attention, mostly due to its discussion of threshold-based forward guidance. However, the paper – “The Federal Reserve’s Framework for Monetary Policy, Recent Changes and New Questions” – also explored raising the inflation target. In an environment similar to the one described above, the paper’s authors simulate a model and find “part of the increase in nominal bond rates perceived by non-financial agents is perceived as a real phenomenon, leading to a reduction in expenditures and prices in the short run.” In sum, formal economic modeling confirms the commonplace intuition that a rise in inflation expectations can be damaging for growth.
A separate critique of this strategy has been discussed by Lars E.O. Svensson — a leading macroeconomist, former Princeton colleague of Bernanke, and recently a deputy governor of the Swedish Riksbank. Svensson recently argued that if a central bank successfully stabilizes inflation expectations, then there is a trade-off between inflation and employment, and higher inflation means lower employment. However, it is inflation relative to inflation expectations that matter for employment — for a given level of realized inflation, higher inflation expectations means higher unemployment. Svensson gives the intuition as “Suppose that nominal wages are set in negotiations a year in advance to achieve a particular target real wage next year at the price level expected for that year…If actual inflation over the coming year then falls short of the inflation target, the price level next year will be lower than anticipated, and the real wage will be higher than the target real wage. This will lead to lower employment and higher unemployment.” When average inflation is below a credible inflation target, it results in higher unemployment. The challenge for a central bank in this situation is to create the demand conditions that will stimulate actual inflation. However, simply raising inflation expectations could be counterproductive – even more actual inflation will need to be realized for there not to be employment loss with a higher inflation target. Generating that actual inflation has proved to be challenging for developed market central banks around the world.
Watch out for the back door
Simply announcing a higher inflation target could lead to higher real interest rates and, ex-post, higher real wages and thus lower employment. There are other ways this outcome can arise. In particular, nominal GDP targeting could have the same effect. Under this approach, the Fed would choose a target path for nominal GDP and keep policy accommodative so long as actual nominal GDP was below that target. Nominal GDP growth can be decomposed into real GDP growth plus inflation. If trend real GDP growth disappoints, then the shortfall in nominal GDP growth would need to be made up in a higher inflation target — leading to the same growth-inhibiting concerns about a higher announced inflation target described earlier. This concern seems particularly relevant at this juncture as many believe (including us) that the Fed is at risk of overestimating the trend in real GDP growth.
The argument for raising the inflation target is not hopeless, but must be carried out in the context of a more comprehensive stimulus plan. Christina Romer has noted how the American New Deal and present-day Japan share an aspiration to affect a regime shift in expectations. Note, however, that in both situations expectations management was complemented by action in both the monetary and fiscal realms. A central bank going it alone to raise inflation expectations can create a situation that might backfire on growth. This is why we believe that even under the leadership of a Chairman like Yellen who is undoubtedly committed to the Fed’s employment mandate, the FOMC will not undertake policy actions that lift inflation expectations above a level consistent with the 2 percent long-run goal.
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