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The Fed’s problem with inflation

What’s at stake: the Federal Reserve raised the benchmark interest rate by one-quarter of a percentage point. The moved surprised no one, but it still

Publishing date
19 June 2017
Silvia Merler

Joseph Gagnon at PIIE argues that the FOMC meeting offered three unexpected items. First, Chair Yellen pointed to "one-off" development in the prices of mobile phone service plans and pharmaceuticals in March, as the main reason the FOMC's preferred measure of inflation has moved away from its 2 percent target to 1.5 percent as of April. Gagnon wonders whether the FOMC is revisiting the bad old days of the 1970s, when it tried to explain away inflation that was too high by pointing to a seemingly endless stream of one-off factors. Second, the FOMC announced the details of how it would begin to gradually shrink its balance sheet and said the process likely would start sometime this year. Yellen refused to say whether the FOMC would hike rates and start the balance-sheet runoff at the same meeting, but Gagnon’s guess is that the balance-sheet runoff may begin in September and another rate hike may wait until December. Third, Yellen was asked about a letter signed by several economists asking the FOMC to consider a higher inflation target or a change in its policy framework to avoid undershooting the current target and she was surprisingly open to this suggestion, saying that it was a very important issue that the FOMC would be studying.

Jared Bernstein also wonders whether the Fed is fighting an old war. Sure the US is closing in on full employment, but the Fed’s preferred inflation gauge, the core PCE, is below the 2 percent inflation target and slowing. It’s decelerated from 1.8 percent in the first two months of this year to 1.6 percent in the last two months. Expectations remain low–under 2 percent–as well. That’s the opposite of what you’d expect if tight labor markets were driving price growth, and a legitimate reason not to tap the growth brakes with another rate bump. Chair Yellen made a case about not getting “behind the curve”, but Bernstein believes this was not very convincing. Looking at the Fed’s projections of future inflation over time, Bernstein argues that the Fed keeps projecting that inflation will climb to the 2 percent target, but actual inflation keeps ignoring their predictions. This suggests a problem with the model.

Sources: Bernstein

Larry Summers offers 5 reasons why he thinks the Fed may be making a mistake. First, the Fed is not credible with the markets at this point. Its dots plots predict four rate increases over the next 18 months compared with the market's expectation of less than two. The markets do not share the Fed’s view that inflation acceleration is a major risk; indeed they do not believe the Fed will attain its 2 percent inflation target for a long time to come. Second, the Fed proclaims that it has a symmetric commitment to its 2 percent inflation target. After a full decade of sub-target inflation, policy should be set with a view to modestly raise target inflation during a boom with the expectation that inflation will decline during the next recession.  A higher inflation target would entail easier policy than is now envisioned. Third, preemptive attacks on inflation, such as preemptive attacks on countries, depend on the ability to judge threats accurately. The truth is we have little ability to judge when inflation will accelerate in a major way. The Phillips curve is at most barely present in data for the past 25 years. Fourth, there is good reason to believe that a given level of rates is much less expansionary than it used to be given the structural forces operating to raise saving propensities and reduce investment propensities. Fifth, the Fed to abandon its connection to price stability, it simply needs to assert that its objective is to assure that inflation averages 2 percent over long periods of time.  Then it needs to acknowledge that although inflation is persistent, it is very difficult to forecast and signal that it will focus on inflation and inflation expectations data rather than measures of output and employment in forecasting inflation. With these principles internalized, the Fed would lower its interest-rate forecasts to those of the market and be more credible. It would allow inflation to get closer to target and give employment and output more room to run.

David Beckworth argues that either the Fed is the most unlucky institution in the world or the Fed has a problem. He believes the Fed appears to have begun having a problem with 2 percent inflation around the time of the Great Recession. The FOMC's summary of economic projections (SEPs) shows a central tendency of FOMC members since 2008 to indicate that they see optimal inflation not at 2 percent, but at a range between 1 and 2  percent (figure below).  The actual performance of the Fed's preferred inflation measure, the PCE deflator, has been consistent with this view. It has averaged about 1.5 percent since the recovery started in mid-2009. Beckworth argues that this is a revealed preference, not a series of accidents caused by bad luck. The Fed has only been explicitly targeting inflation at 2 percent since 2012, but many studies have shown it to be implicitly doing so since the 1990s. So this truly has been an eight-year plus problem for the Fed and one that makes Janet Yellen's remarks all the more disappointing to hear. One would think after almost a decade of undershooting 2 percent inflation there might be an acknowledgement from the FOMC that it is “treating 2 percent as a ceiling rather than a target” (as argued by Minneapolis Fed President Neel Kashkari).

Source: Beckworth

Cardiff Garcia at FT Alphaville counts himself among the critics of the Fed’s move. He argues that from the very beginning of the recovery, the Fed had too pessimistic a view of the economy’s potential to reduce unemployment before running into structural obstacles. The Fed also became still more pessimistic about the potential for the labour market to heal through the early years of the recovery. The expected long-run rate only started falling again in mid-2013, as the actual unemployment rate continued its steady downward trend. With the unemployment rate now having fallen all the way to 4.3 per cent and inflation still quiescent, the Fed would appear to have long had an excessively gloomy view of the economy’s capacity to recover. The question then is: Was it right not to have expected the rate to fall as much as it did? Given the privilege of hindsight, it’s impossible to say yes. In response to a question, Janet Yellen suggested that estimating the long-run unemployment rate is always a difficult exercise v  . Garcia argues that she’s right, but learning from the past means owning up to prior mistakes. Had the Fed better understood the nature of the economy early on, it would have seen that it could be more aggressive in its reaction function. A decent case can be made that the Fed’s continued failure to produce an economy that sustainably keeps inflation near the target, and which includes healthier wage growth, is traceable to having committed this early error. Given that the long-run estimate for the unemployment rate remains above the actual rate despite lacklustre inflation and wage growth, another case could be made that the Fed is still committing it.

About the authors

  • Silvia Merler

    Silvia Merler, an Italian citizen, is the Head of ESG and Policy Research at Algebris Investments.

    She joined Bruegel as Affiliate Fellow at Bruegel in August 2013. Her main research interests include international macro and financial economics, central banking and EU institutions and policy making.

    Before joining Bruegel, she worked as Economic Analyst in DG Economic and Financial Affairs of the European Commission (ECFIN). There she focused on macro-financial stability as well as financial assistance and stability mechanisms, in particular on the European Stability Mechanism (ESM), providing supportive analysis for the policy negotiations.

    Between May 2011 and August 2012, she worked as Research Assistant to Jean Pisani-Ferry, then-director of Bruegel. During 2009 and 2010, while a student, she collaborated to research projects of Bocconi University and the Italian ENI Enrico Mattei Foundation (FEEM). During this period she was involved in the MICRODYN project, working on a cross-country and cross-sectors analysis of productivity developments with firm level data, and on the POLINARES project (“Policy for Natural Resources”).

    Born in 1986, she holds a MSc in Economics and Social Sciences at Bocconi University in Milan and graduated in 2011 with a thesis on Current Account Imbalances within the Euro Area. She obtained a BA in Economics and Social Sciences from the same university in 2008, with a thesis on Ukraine and Moldova in the European Neighbourhood Policy.

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