CNBC’s Fed survey Link: http://www.cnbc.com/id/46746639 [7] exposes a great deal of uncertainty about what the Fed plans to do. Some see the Fed taking another voyage on the Good Ship QEIII. Some see the Fed twisting again. But opinion is scattered.
In late January of this year the Fed presented us with a new policy manifesto; Link: http://www.federalreserve.gov/newsevents/press/monetary/20120125c.htm [8]. This laid out a statement of the Fed’s policy and its objectives. Yet, it has not given us much clarity on what the Fed actually will do. The Fed has adopted what might be called an Old Testament view of its dual mandate rejecting the modern Volcker-Greenspan version that took conflict out of Fed policymaking by focusing on inflation control as the vehicle to maximum growth. Now we are back in a world of ‘dual’ or ‘dueling’ mandates; the the Fed must give us price stability (very specifically defined) and deliver low unemployment, too. Fortunately the Fed was not put on the hook to deliver world peace. Still, this new world introduces a lot of complexity.
But what is interesting is the Fed’s adoption of 2% in the overall PCE price deflator as the inflation metric that is most consistent with its ‘stable prices’ mandate. That’s it. The Fed mentions (a) ‘2%’, as a (b) ‘year-over-year rate’ to be achieved by (c) the ‘PCE’ (d) ‘over the longer run’ and that is all the guidance we get.
Ben Bernanke has been in favor of a price rule since he became Fed Chairman but has not been able to put it in place. Barney Frank was the Chairman’s initial nemesis; he argued that he did not want an inflation target without a growth or unemployment target. But no man can serve two masters. Yet, here is the Fed with two objectives, and, admittedly, a lot of hand-waving about the other objective. Even now as this metric is announced it is sharing the spot light with a second quasi-commitment to lower the rate of unemployment and that in turn muddies the water on what the Fed is promising on inflation. What is this statement that is not a promise or a pledge?
With some hindsight it is unclear why the Fed needs this rule and what purpose it will serve. It is interesting to note that the Fed used to operate with the informal goal of keeping core PCE inflation near 2%. The Fed has both adopted a firmer expressed notion of what denotes price stability and it has changed its notion of the price it is to stabilize (to headline inflation from core).
Interestingly over the past 10-years the Fed has kept the PCE headline to a compound annual rate of inflation of 2.3%; it has kept the core PCE to 1.9%. In short the Fed has kept the overall price level close to 2% and has kept the core below its 2% mark. Since Bernanke himself has been Chairman those results are 2.1% for overall inflation and 1.9% for core inflation (over six years). With such a track record why formalize something that has been working?
Is the new price metric a beard of sorts? The 2% PCE is not actually a pledge. It is the number the Fed has said is most consistent with its objective. Yet the Fed has made no price level pledge to keep inflation ‘from here on out averaging 2%’ (even though it has come close to doing that over 10-years and over the past six years, even with an energy shock). All that the Fed is promising to do is to return inflation to 2% when/if it deviates and so do so as quickly as practicable.
This raises two questions. What will inflation actually average and how will the Fed assure us it is something close to 2% if it has a second ‘equal’ objective? The Fed cannot ward off the impact of energy prices on headline inflation except over multi-year periods, and yet if the Fed is trying to control headline inflation how will it assure us that as it leans to push the unemployment rate down, it has not strayed too far from its inflation objective?
The headline price metric alone will take some getting used to. Over the past ten years the Fed’s average miss on core inflation (Dec-to-Dec) was 0.4 pct points. Its average miss on the headline was 0.7 pct points. Large short run errors in hitting the headline objective can breed credibility problems. Over ten years, the Fed experienced six back-to-back annual periods in which the PCE headline was above 2%. In four of those the core also was over 2% (but by much less than the headline). So how does the Fed have any credibility left to pursue the objective of lowering the unemployment rate at such a time? Last year the PCE headline rose by 2.5% with the core at 1.9%. If the Fed were using core as a benchmark it could claim flexibility but since it is not doing that any more… what will it do?
Does the Fed think that the statement on inflation even though it is not a pledge will anchor inflation expectations by itself and give the Fed flexibility? Or will markets get nervous when inflation drifts away from its newly appointed sweet spot? We have a lot to learn about how the markets and the Fed will react. And this is just in terms of trying to puzzle out an inflation metric that is not a pledge. In some ways by naming a number and an inflation gauge the Fed has confused us even more. If the inflation goal were a pledge we could see the Fed using periods of flexibility to reduce unemployment CONFIDENT that it would fight back and reduce any inflation that tried to bulge. But without a pledge, a promise or a true target, we are wary that inflation misses will just add up to more inflation and the toothpaste will not be squeezed back into the tube. In that case the inflation metric is a beard.