There was an interesting development in US monetary policy last week with the announcement by the Fed that it would in future be thinking of – and operating – its inflation targeting regime a bit differently than in the past. Note that for the last decade or more inflation has typically been below the 2 per cent annual rate (PCE deflator measure) the Fed described itself as targeting.
The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.
Note that the US system itself is very different from our own. Congress gave the Fed a single goal a long time ago, expressed in a way no one would today,
Section 2A. Monetary policy objectives
The Board of Governors of the Federal Reserve System and the Federal Open Market Committee shall maintain long run growth of the monetary and credit aggregates commensurate with the economy’s long run potential to increase production, so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.
And then left everything to the Fed. The President (or the The Treasury) has no further power over how goals are conceptualised and operationalised, other than through powers of appointment (and potentially dismissal).
And last week, after a review that has gone on for some years, the Fed announced a new articulation of its target (emphasis added)
The Committee reaffirms its judgment that inflation at the rate of 2 percent, as
measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee judges that longer-term inflation expectations that are well anchored at 2 percent foster price stability and moderate long-term interest rates and enhance the Committee’s ability to promote maximum employment in the face of significant economic disturbances. In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.
Reasonable people can probably differ on the merits of this change which, at least on paper, represents quite a material shift from the way inflation targets have been articulated pretty much everywhere since the regime was developed in the 1990s.
Previously, bygones were treated as bygones: if inflation was above (below) target for a period of time, the goal was to get it back down (up) to target over some reasonable period, and thus to support the goal – repeated in that Fed statement – of keeping longer-term inflation expectations at close to the target level. Mistakes would happen, shocks would happen, but there was no reason to think they would be consistently on one side of the target rather than the other.
There was always the alternative of price level targeting. People had discussed the option for years, researchers had analysed it, but no one (no country, no central bank) had ever found it sufficiently attractive to adopt as the basis for running policy. There are good reasons for that. Under price-level targeting, bygones are not bygones. Run a few years with inflation higher (lower) than consistent with the price level target, and the central bank then has to deliberately and consciously set out to offset that deviation with a few years of inflation lower (higher) than the rate consistent with the longer-term price level target. And since there are very few long-term nominal contracts, it was never really clear what was to be gained by a price level target. And there were real doubts as to whether such targets would prove to be credible and time-consistent. Would central banks really drive inflation a long way below target – with likely unemployment consequences – just to offset a period of above-target inflation? At the Reserve Bank we never thought that likely or credible.
But the Fed has decided to give it a try, at least after a fashion. As expressed, their new self-chosen goal is asymmetric – there is no reference to how they would treat periods in which inflation had run persistently above 2 per cent – and it has the feel of something a bit jerry-built and opportunistic.
Like a number of other central banks, the Fed has undershot its inflation target for some years now. In part, as they themselves identify, that reflected mistakes in assessing how low the unemployment rate could go without resulting in higher trend inflation. Arguably there is enough uncertainty about that – and other indicators of excess capacity – that it no longer really made much sense to try to set and adjust the Fed funds rate on the basis of macroeconomic forecasts (a common description of inflation targeting was that it was really “inflation forecast targeting”). If so, one might have to wait until one actually saw inflation itself moving clearly upwards. to or beyond target, before it would be safe or prudent to tighten monetary policy. But since monetary policy adjustments only work with a lag – a standard line is that the full effects take perhaps 18-24 months to be reflected in the inflation rate – if such an approach was taken seriously it would almost guarantee that if inflation had been persistently below target, there would be at least some offsetting errors later. In a New Zealand context – on which more later – I’ve argued that against a backdrop of 10 years of having undershot the target, and inflation expectations quite subdued, if we ended with a few years with inflation a bit above 2 per cent it shouldn’t be viewed as particularly problematic. As an outcome, it might not be a first-best desired thing, but – given the uncertainties – it wasn’t worth paying a significant price (eg in lost employment) to avoid.
But that has a different feel to what the Fed is now articulating. They are now saying that they expect to consciously and deliberately set out to offset years of undershoots with years of overshoots. And you can be sure it won’t be a case of careless drafting but of conscious choice.
There is perhaps one good argument for this approach. Since the Fed refuses to use monetary policy instruments themselves aggressively to counter directly the persistent inflation undershoot, and more latterly the recession – notably refusing to take their policy rate even modestly negative, let alone the “deeply negative” that people like former IMF chief economist Ken Rogoff have called for – they want to try to hold up inflation expectations by persuading some people that they won’t be aggressive on the other side either – jumping to tighten monetary policy at the first glimmer of sustained recovery, the first hint of higher inflation.
There are some hints in market prices – breakeven inflation rates, between indexed and conventional government bond yields – that the announcement generated a small move of this sort. But…..breakeven inflation rates in the US had been rising fairly steadily for the last few months, and even now are only back to where they were at the end of last year. That isn’t nothing – especially against the economic backdrop – but at the end of last year five and ten year breakevens were not high enough to be consistent with the Fed meeting its own target in future. And now they certainly aren’t consistent with inflation outcomes being expected to overshoot the 2 per cent inflation target for several years, to consciously offset the past undershoots.
And then there is the problem of time-consistency. It is one thing to suggest now that you – or, typically, your successors – will be quite content to deliberately target inflation persistently above target for several years several years in the future. It is quite another to actually deliver on that. Like many other central banks, the Fed has consistently undershot its target for a long time, preferencing one sort of error over another. Why will people believe things will be different this time? The Fed isn’t operating monetary policy more aggressively right now. And if the core inflation rate does look like getting sustainably back to 2 per cent in a few years, won’t there be plenty of people running arguments like “well, that was then, that statement about overshooting served a purpose in the crisis, but this is now, the economy is recovering, and anyway who really wants core inflation above 2 per cent. Remember, inflation itself is costly.” And any rational observer will have to recognise that risk.
In the absence of a symmetrical approach to errors, one has to wonder why not just raise the inflation target itself – something various prominent economists have called for over the years since 2008/09. But perhaps to have done that would have stretched credulity just too far: it is one thing to set an inflation target at, say, 3 or even 4 per cent, but another to do effective things to actually deliver such an outcome. The monetary policy the Fed has actually chosen to run – and they are all choices – over the last decade hasn’t successfully delivered 2 per cent inflation, let alone anything higher.
Interesting as the US change of stance is, my main focus is still New Zealand, and so I was interested to spot a short article on Bloomberg yesterday. in which the journalist reported on our Reserve Bank’s response to questions about the new Fed monetary policy strategy. Somewhat surprisingly, Orr’s chief deputy on monetary policy Christian Hawkesby was willing to go on record.
“Our observation is that the U.S. Federal Reserve implementing its approach through ‘flexible average inflation targeting’ has a number of parallels with the Monetary Policy Committee’s stated preference to take a ‘least regrets’ approach to achieving its inflation and employment objectives,” Hawkesby said in response to written questions from Bloomberg News. “That is, if inflation has been below the mid-point of the target range for a time, the Committee’s least regret is to set policy where inflation might spend some time above the mid-point of the target range in the future.”
That final sentence might initially look the same as what the Fed is now saying, but it isn’t really the same thing. From memory, we have seen lines of this sort once or twice before from individuals at the Reserve Bank, and they seemed then to be saying something like what I was suggesting earlier: since it is hard to forecast with confidence, it probably doesn’t make much sense to be tightening until you are confident core inflation is actually back to target, and if so the lags mean there has to be some chance there will be a bit of an overshoot. That is different in character from actually setting out to deliver above-target outcomes.
As it is, the policy documents the Reserve Bank works to still explicitly require them to focus on the target midpoint, and explicitly treat bygones as bygones in most circumstances – so long as inflation expectations remain in check.
Here is the inflation bit of the Remit – the document in which, by law, the Minister of Finance sets out the job of the MPC.
The operative word there is “future” – which has been in target documents (previously Policy Targets Agreements) – for many years. Bygones are supposed to be treated as bygones, with a focus always on inflation in the period ahead.
I checked out the latest Letter of Expectation from the Minister to the Governor, dated early April this year (so well into the current crisis). These documents have no legal force, but the Minister of Finance is the ultimate authority, including in deciding whether the Governor and MPC members keep their jobs. There is no mention of the inflation target, and no suggestion that the Minister thinks the MPC should be reinterpreting their legal mandate to target inflation outcomes above the “2 percent midpoint” (only the strange suggestion that the Bank should be “ensuring a Māori world view is incorporated into core functions” – whatever that might (or might not) mean for monetary policy.
Just in case, I read through the minutes of each of the Monetary Policy Committee meetings this year. Unsurprisingly there was no hint of any idea of actively targeting inflation above the target midpoint – despite 10 years of outcomes below target. Consistent with that, in February the MPC has adopted a very slight tightening bias consistent with forecasts that delivered medium-term inflation outcomes right on 2 per cent.
But, of course, none of this should be surprising given how little the Reserve Bank has actually done this year. We can debate what contribution the LSAP programme may or may not have made, but the bottom line – as even the RB says – is how much interest rates have fallen, Term deposits rates have fallen by perhaps 100-120 basis points. Mortgage interest rates seem to have fallen by similar amounts (and as the Bank acknowledges their business lending rate data are inadequate for purpose). Inflation expectations have fallen quite a lot – affirmed again in yesterday’s ANZ survey – which is both a problem directly (people no longer expect 2 per cent to be achieved) and because it diminishes the impact of those (quite limited by historical standards) falls in nominal retail rates. And, of course, the exchange rate is only slightly lower than it was before the Covid economic slump.
And what of the inflation outlook? With all the Reserve Bank thinks it has thrown at the situation – all the beneficial impact it thinks it is getting from the LSAP – even the Bank’s August inflation projections had inflation below the bottom of the target range for two years from now, only getting back to 2 per cent – on their numbers, on which they have a long-term record of being over-optimistic – three years from now. By then it would have been almost 14 years with core inflation continuously less than 2 per cent.
Despite those years of actual undershoots – the sorts of ones Hawkesby alluded to in his response to Bloomberg – there is no hint at all in the actual conduct of policy of the Reserve Bank consciously and deliberately acting as if it is willing to see inflation come out a bit above 2 per cent (of course, it could still turn out that way, events can change and all forecasts have considerably margins of uncertainty).
After all, having failed in one of their prime duties – to ensure banks could easily adjust to the negative interest rates they recognised that the next recession might require – they now suggest that they are bound by a rash pledge they made in March, not to change the OCR at all for a year. No one except them regards such a pledge – and certainly not one made when the Bank itself was still underestimating coronavirus – as binding. But they choose to do so, choose to run the consequent risks. Thus, the OCR is still set at 0.25 per cent, only 75 basis points lower than it was at the start of the year. 90 day bank bill rates, as a result, sit at about 30 basis points. By contrast in Australia – where the Governor is also pretty hesitant about using monetary policy aggressively – the comparable rates are about 10 basis points. Even if one accepted as valid the Governor’s claim that banks can’t cope with negative rates – and I don’t; people adjust quickly when they have to, and those who are best-prepared get a jump on the rest, as it should be – there is no reason at all not to have the OCR at zero now (and don’t tell me systems can’t cope with zero either, since there are numerous non-interest bearing products). The MPC chooses not to change, and as a result monetary conditions are tighter than they need to be. Of course, 25 basis points in isolation isn’t huge – in typical recession we have 500+ points of easing – but when so little has been done, when inflation forecasts and expectations are so low, and against the backdrop of a consistent undershoot, it is inexcusable not to use the capacity that unquestionably exists now, not idly talking of possible cuts sometime next year.
The MPC is running risks, but they are the opposite of those the Assistant Governor alluded to. His attempt to suggest some sort of parallel with the new Fed approach – which, in fairness, we have yet to see making real differences to policy – has the feel of opportunistic spin.
(For those recalling my past emphasis on New Zealand inflation breakevens, yes I am conscious that they have risen a long way in the last few weeks. I’m not sure quite what to make of that – especially as it has been reflected in a sharp fall in real yields (20 year indexed bond (real) yields are down 40+ basis points over August) – and it is certainly better than the alternative. But we still left with inflation breakeven numbersthat, even on the surface, are no higher than they were at the end of last year, when they were not consistent with the Bank consistently delivering on the inflation target,)