The Fed has begun implementing its new communication strategy. Here’s what the message seems to be.
Noteworthy among the information released by the U.S. Federal Reserve last week was a statement of the FOMC’s longer run goals and policy strategy. A key section reads:
The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. 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.
This represents an important step in the direction of an explicit inflation target, which some academic research suggests might help lead to greater financial stability. It’s very useful to connect this statement of longer run goals with other details released last week on what the Fed is expecting over the next several years. A key takeaway from the latter is the Fed’s expected behavior for the PCE deflator:
|Upper End of Range||-||-||-||-||-||2.5||2.3||2.1||2.0|
|Upper End of Central Tendency||-||-||-||-||-||1.8||2.0||2.0||2.0|
|Lower End of Central Tendency||-||-||-||-||-||1.4||1.4||1.6||2.0|
|Lower End of Range||-||-||-||-||-||1.3||1.4||1.5||2.0|
So the FOMC is saying that it would like inflation to be about 2% annually, but is expecting it only to be 1.4 to 2.0% over the next 3 years. Putting 2 and (less than) 2 together, the FOMC is telling us that, based on its price stability objective alone, the Fed is expecting inflation to be lower than it would like. In other words, even if the economy were at full employment, a little more stimulus would be called for. And of course, nobody thinks the U.S. is anywhere close to full employment. The Fed’s forecast is for an unemployment rate between 7.4 and 8.1% for 2013.
Interpretation: the Fed is expecting to exert some additional stimulus. Large-scale asset purchases– referred to popularly as more “quantitative easing”– are the primary tool available. So, if your motto is “don’t bet against the Fed,” then I wouldn’t bet against more QE during 2012.
But what’s the Fed waiting for? One issue is that although the Fed is expecting inflation to be below target for the next 3 years, and although the actual inflation rate has come in below their announced target over much of the last 4 years, since last April the year-over-year change in the PCE deflator has been running a bit above 2%.
The Fed is not alone in thinking that inflation will be lower over the next few years than it was in 2011. For example, the median respondent to the Federal Reserve Bank of Philadelphia’s Survey of Professional Forecasters is anticipating 1.6 to 1.8% annual headline PCE inflation for 2012 and an average over 2011-2015 of 2.1%. A new survey by the Federal Reserve Bank of Atlanta found that businesses in the southeastern United States are on average expecting their costs per unit this year to rise by 1.8%. And expected inflation as inferred from the gap between nominal and inflation-protected 5-year Treasury securities has been coming in below 2% since last summer.
But although professionals may be inclined to agree with the Fed, ordinary Americans seem less so. The University of Michigan survey of consumer attitudes has been reporting expected inflation rates that are a hundred basis points higher than the professionals.
Why worry about inflation at all, even if the public is right and it turns out to be 3%? Here I think the key question is the limits on what the Fed could do to help. Do higher inflation rates really help the economy, and, once we open that door, could the Fed keep it under control without further economic damage? As long as there is a non-neglible prospect of outright deflation, there’s no question in my mind that trying to get a little more inflation is a good idea. A Fed policy of communicating clearly that they’re simply not going to allow deflation has always made a lot of sense to me. But once inflation goes above 3%, it’s far less clear that more monetary stimulus can do any good.
Could the Fed forge ahead anyway, with a communication strategy of, “yes, we know many of you are expecting higher inflation, but we’re the experts and we say you’re wrong”. Unfortunately, a key element of the success of anything the Fed tries to do is that the market has to believe the Fed can and will carry out what it says. Credibility is the only reason that the Fed’s announcement that conditions “are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014″ has any effect at all. For that matter, the market signal that is generated by large-scale asset purchases may be a key mechanism by which QE itself makes any difference. Without credibility, the Fed is only a paper tiger. The more political opposition the Fed faces, the less it can actually accomplish.
The Fed would like to do more, and expects it may soon have to do more. But it isn’t ready to act quite yet.