Over the past 4 years, the Fed has adjusted its policy instrument a total of nine times. In each of those nine cases, the Fed funds target was increased by 1/4%. In each of those nine cases the reason for the increase was identical. All nine increases were done with the goal of reducing inflation—holding inflation down to 2%. That’s it. Period. End of story.
And now there is a great mystery that needs to be solved. Why is inflation running slightly below the Fed’s 2% target? (Core PCE inflation was 1.94% in December 2018.) Here’s Bloomberg:
It’s like a cold case that still baffles investigators. After years of rock-bottom interest rates and with unemployment at 3.8 percent, where is the inflation? It’s a whodunit that hangs heavily over the Federal Reserve.
There are three culprits:
There’s a blizzard of theories aiming to solve the riddle, each with its own set of monetary policy implications. Most economists believe the answer lies in some combination of these ideas, rather than a single culprit.
1. Slack
One bundle of theories holds that the labor market simply isn’t as tight as most economists believe. . . .
2. Secular Disinflation
Economists see a variety of longer-run structural changes that may put downward pressure on inflation. For example, in an aging population older people save more and spend less; baby boomer retirements drive down average compensation. The collapse of organized labor, growing concentration among employers and exposure to international trade represent others. . . .
3. Anchored Expectations
Our last category seems to be the Fed’s favorite person-of-interest. Fed Chairman Jerome Powell told Congress on Feb. 26 that “inflation expectations are now the most important driver of actual inflation.” . . .
I’m going to propose another possible culprit:
4. Excessively tight money
The Fed adopted an excessively tight monetary policy in 2015 and 2016 when it began raising its target interest rate, and this caused the recent undershoot of inflation. (Policy was closer to target in 2018, when the inflation undershoot was small.)
One of the oddities of macroeconomic discourse is that almost no matter what goes wrong, the central bank is not blamed. And that’s even true if the central bank has taken nine consecutive “concrete steps” that would be expected to produce exactly the sort of policy failure that actually materialized. It’s as if I pumped nine consecutive bullets into someone’s chest, and the doctor was puzzled as to why the victim was suffering from chest pains. (In fairness, the inflation miss is rather small and not a major problem for the economy at the moment. So the gunshot analogy is misleading in that respect.)
This also caught my eye:
“It’s almost surely true that inflation is less tightly linked to what’s going on in the real economy than it used to be, and that matters a lot,” said Jeffrey Fuhrer, director of research at the Boston Fed.
Yes, but it’s still pretty closely linked to what’s going on in the nominal economy.
I suppose one could argue that Fed policy has no influence on inflation. But if Fed policy has no effect, then why agonize over policy failures? Of course that would also raise the question of why core PCE inflation is currently 1.94%, and not 23.56%, or 15.45% or negative 11.57%, or some other number. Did 1.94% happen by luck? It seems suspiciously close to 2%.
So let’s say the Fed is capable of controlling inflation. I come back to the original question: Why is Fed policy not considered one of the possible culprits for inflation slightly below target? Especially given that the Fed has tightened policy nine times, with the express goal of holding down inflation.
Very strange.
READER COMMENTS
Iskander
Mar 26 2019 at 11:50am
The reasons that Bloomberg article suggests for secular disinflation hopelessly confuses level vs growth effects for the price level. Not to mention some of them (the most productive workers retiring) would tend to raise the price level, for a given rate of NGDP growth.
Garrett
Mar 26 2019 at 11:56am
Notably, DXY went from around 80 to 95 (where it is now) around the end of 2014
John Hall
Mar 26 2019 at 1:10pm
Among the people I work with, there is a lot of skepticism and push-back against the idea that central banks are responsible for weak inflation in developed economies. There is much more interest in the Philips curve, secular stagnation, or demographic explanations. Usually when I say that central banks can create more inflation, the usual response is “what more can they do?” I don’t think anyone has ever been satisfied by my responses to that question…
Of course, at the end of the day, what matters much more for us is not “what should the Fed do” but “what is the Fed going to do and what are the consequences.”
jj
Mar 26 2019 at 1:47pm
Great post. Your first two paragraphs really strip away all the misleading noise and get to the heart of it.
LK Béland
Mar 26 2019 at 2:40pm
I think that a better analogy is a car traveling on a slightly downwards slope. You’d expect it to accelerate. The driver presses nine times on the brakes. The car is not picking up speed. The media then writes reports about strong headwinds and friction limiting velocity.
Scott Sumner
Mar 26 2019 at 8:44pm
Everyone, Good comments. The people John refers to are out there, but I have trouble understanding how anyone could ask, “what more could they do?”
Have these people ever considered that if the Fed were trying to raise inflation, then it might not have wanted to raise rates 9 times in a row?
Ahmed Fares
Mar 26 2019 at 10:20pm
The Fed adopted an excessively tight monetary policy in 2015 and 2016
Okay, how about this for an explanation…
Monetary policy operates with long and variable time lags, typically six to eight quarters. The Fed tightens to have a neutral interest rate when the output gap closes.
Then we get Trump and all the attendant uncertainty.
While markets can handle risk, they can’t handle uncertainty, so corporations don’t invest. So while monetary looks tight in retrospect, there’s no way any central bank could have predicted something like Trump.
What’s Trump going to do next? I don’t know either. We’re all waiting for the next Twitter tweet. The question to ask is what’s the counterfactual had Trump not been elected president.
Benjamin Cole
Mar 26 2019 at 11:39pm
One of the oddities of macroeconomic discourse is that almost no matter what goes wrong, the central bank is not blamed.–Scott Sumner.
Well, in the modern era central banks are rarely criticized for being “too tight.”
The financial media for decades has sermonized about pending hyperinflation, and even such credentialed figures as Martin Feldstein have chronically predicted higher inflation, often in ominous tones.
We do have the hyper-malleable intellectual gymnast Stephen Moore, who lambasted the Fed for being too loose until some hours ago, but now says Trump should remove Powell for being too tight. Moore’s logic is now explained by some sort of genuflecting and reverential obeisance to controlling commodity prices.
A still relevant question is “Can the US economy prosper with the Fed’s 2% inflation ceiling, or is a higher target needed, or a inflation band, say of 2% to 3%?”
I think NGDPLT would be better, but still the question remains, at what level does an NGDPLT act as a noose on real growth?
If 3+3 is best (inflation and real growth), that suggests a 6% NGDPLT target.
A peevish fixation on inflation is not a monetary policy.
Brian Donohue
Mar 27 2019 at 10:00am
The Fed probably tightened too much, too fast but not by a lot.
The headscratching about what is going on is itself mystifying.
If the Fed needs to loosen policy, maybe it’s time to start chipping away at IOER. Banks have had a whole decade of coddling here.
Michael Sandifer
Mar 27 2019 at 12:45pm
I’d like to see the Fed Funds rate at least 1 percentage point lower. I think r* is at least 1 percentage point below the current FFR, if not at least 1.5% lower.
I like that Moore wants the FFR to be lower now, but not within the inflation targeting regime, because I agree with Scott that the Fed tends to panic and slam on the breaks when inflation surprises too much above target. I’d like a 5% NGDP target.
Also, Moore is just too ignorant to be on the FOMC.
Phil Murray
Mar 27 2019 at 12:55pm
Stock prices are up more than 200% since the Great Recession. Is that the inflation?
Brian Donohue
Mar 27 2019 at 3:06pm
Related: what would Clousseau make of a 3-year Treasury yield that fell by 91 basis points between 11/8/2018 and today (from 3.05% to 2.14% in 4-1/2 months)?
When is the first rate cut?
Thaomas
Mar 27 2019 at 4:31pm
The problem is the target: The fed should be doing monetary policy (whether by setting ST interest rates, buying or selling longer term instruments, changing the IOR, or other things it had never done for policy reasons like buy/sell foreign exchange) in order to push the price level toward the target long tern trend it has set for the price level to increase.
All of the proffered “reasons” are just reasons that Fed might have to pus harder that it might have expected to get the price level back on target.
Ben Polidore
Mar 27 2019 at 4:33pm
Hey, scott. I thought you might like this post on bloomberg:
This Yield Curve Alternative Also Shows Rising Recession Risk
By Ye Xie
(Bloomberg) —
An obscure market measure, which a Fed research papersuggests is better than yield curves for predicting recessions, points to an increased risk of an economic contraction. The so-called near-termforward spread, or the difference between the forward rate on Treasury bills six quarters from now and the current three-month yield, fell to -44 bps today, the most negative in more than a decade. (H/T to Medley Global Advisors’ strategist Ben Emons for pointing it out.)
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