Oh no…with the Federal Reserve in a state of flux as one Chairman prepares to step down and another (shock horror, who is not an economist) takes over, some of his colleagues who think they’ve found the “Holy Grail” of monetary policy are agitating for change. And, dare we say it, hoping it will raise their own prestige no doubt. We are specifically referring to John Williams, President and CEO of the San Francisco Fed, but it’s not just him. What they have in their crosshairs is the Fed’s 2% inflation target. It’s too low. According to Bloomberg.
Federal Reserve officials are pushing for a potentially radical revamp of the playbook for guiding U.S. monetary policy, hoping to seize a moment of economic calm and leadership change to prepare for the next storm. While the country is enjoying its third-longest expansion on record, inflation and interest rates are still low, meaning the central bank has little room to ease policy in a downturn before hitting zero again. With Jerome Powell nominated to take over as Fed chairman in February, influential officials including San Francisco Fed chief John Williams and the Chicago Fed’s Charles Evans have taken the lead in calling for reconsidering policy maker’s 2 percent inflation target.
“It’s a good time given the shift in leadership,” Atlanta Fed President Raphael Bostic told reporters on Tuesday in Montgomery, Alabama. “The new guy comes in and they are able to really think about, how should this work, how do I think this should work, and is it compatible with where we’ve been and where we are trying to get to?”
The justification for the policy changes these Fed officials are advocating boils down to what Williams refers to as a “Low R-star World”, i.e. one where the natural rate of interest is very low.
The problem with what they have in mind is the Fed’s explicit 2% inflation target. However, it’s a relatively recent adoption, so Williams and Evans have to tread carefully, so as not to offend too many incumbents.
The Fed in 2012 officially settled on 2 percent inflation as an explicit target for the price stability half of its dual mandate from Congress. The other goal is maximum sustainable employment. The move formalized a policy they’d been following in practice for several years, and it was backed by careful logic: 2 percent is high enough to ensure that workers continue to get raises and to give the Fed some cushion against deflation. Other advanced economies aim for a similar level. Yet Fed officials, most loudly Williams, have been urging the policy-setting Federal Open Market Committee to revisit that approach. The reason? The target was settled at a time when officials thought they’d have no problem in lifting interest rates to 2 percent or higher without choking off growth. But fundamentals in the economy have changed since the crisis. Growth and productivity have been tepid. As a result, the so-called neutral level of interest rates -- which neither speeds up or slows the economy - is very low by historic standards, leaving the Fed with less wiggle room.
What it boils down to is these senior Fed officials want to let the inflation genie out of the bottle just that little bit more…let the economy run “hot” for a while, without losing control, of course. Then they can cut rates more aggressively in the next downturn and “save us”.
Allowing prices to rise slightly higher would give the Fed more scope to ease in the next downturn. The federal funds rate is quoted in nominal terms, or not adjusted for inflation. So if neutral stands at 0.5 percent, in real terms, and prices are rising at a 3 percent pace, the Fed can get rates as high as 3.5 percent before policy would be restrictive. If inflation were only 2 percent, that level in nominal terms would be 2.5 percent.
Which sounds like a policy of less adherence to price stability, although we could be mistaken. Meanwhile, Williams is trying not to be too brazen and is advancing his ideas cautiously.
Williams told reporters in early November that he favors discussing a new framework now, though he doesn’t want to tie the talks to near-term strategy. “It would be optimal to have a decision around what’s the best framework that we should be using well before the next recession,” he said, because it will “take some time” for officials to hammer out such an important policy. Alternative approaches could include allowing prices to overshoot for the same amount of time they undershot -- commonly called price-level targeting -- or even raising the desired inflation goal to 3 percent.
There we have it, just more confirmation that central bankers are, at heart, inflation junkies. Yep…we knew it all along, of course, but it’s fascinating to watch them articulate it in an innocent manner. As Bloomberg informs us, yet another Fed Governor, Harker, is ready to overhaul policy when Powell sits in the Chairman’s chair.
“There’s a host of possible options, and I have not settled on any one of those yet,” but it merits a discussion “now,” Philadelphia Fed President Patrick Harker said in an interview with Bloomberg News earlier this month.
“This is a discussion we’re going to have to have within the Fed, and within the broad economic community."
There’s good reason to discuss the future of monetary policy now. The unemployment rate is low and growth is humming along steadily, and though inflation remains below target, officials expect it to pick up in coming months.
In this period of economic calm, economists can debate the merits of different approaches slowly and carefully. “Developing a new framework prior to the next zero-lower bound episode allows time for a shift in the nature of forward guidance -- and communications more generally,” Evans said Tuesday in Frankfurt. The policies would then be better understood, better refined, and “therefore, likely be more effective,” he said.
So we need to prepare for a change in Fed policy and one that justifies a higher inflation target. Were they to achieve this target, it will obviously be bad news for the 80% of American’s whose incomes are already trailing the cost of living as we discussed.
But being stupid in an intellectual way is a defining characteristic of this generation of central bankers.