I'm not getting much feedback on my Bush the actor pretending to deficit spend irresponsibly argument (hint, hint!). Today there are two US professional economists areguing the case for an open comittment to inflation. Of course they're using a fairly orthodox inflation targeting argument of the kind I don't really swallow (not in its simplistic monetarist for anyway) but still, if you take this argument seriously, wouldn't they be doing what they are doing over at the US Treasury? Or what is it I'm missing?
The Federal Reserve has won its long war against inflation. And, with victory, go the spoils - evident in President George W. Bush's decision to reappoint Alan Greenspan for another term as chairman. But to ensure an enduring legacy, Mr Greenspan now needs to solve a different problem: inflation is too low, rather than too high. How so? The economy needs a buffer of inflation above price stability to ensure that monetary policy has room to work effectively in the event of shocks to aggregate demand. The inflation rate should be high enough to allow the economy to take a shock without falling into deflation.
During its anti-inflation campaign, the Fed opportunistically accepted recessions when they inevitably occurred because they generate disinflationary dividends. Then, in subsequent recoveries, the Fed would pre-emptively increase rates before there was any sign of a rise in inflation.Opportunism and pre-emption made sense when the Fed's goal was to push inflation lower. The mistake of tightening too much or easing too little had the benefit of clipping inflation. Cycle by cycle, the war against inflation was fought, with each recession drawing us closer to victory.
The logic no longer holds, however, now the promised land of price stability has been reached. There would be nothing opportunistic about going lower on inflation. To the contrary, doing so would be a deflationary mistake. Similarly, pre-emptive tightening makes no sense if there is no buffer between the actual inflation rate and price stability, as at present. Without a buffer, the Fed should welcome a modest rise in inflation.Such an outcome would provide the economy with greater room to absorb the inevitable adverse shocks. The deflationary costs would be very high in the present post-bubble world, given the heavy debt burdens of businesses and households. And the Fed has only 1.25 percentage points of interest rate ammunition left, even less if it wants to avoid putting the money market mutual fund industry out of business.
So what should Mr Greenspan and Fed colleagues do? First, they should junk the doctrines of opportunistic disinflation and pre-emptive tightening. Such a declaration would pull down expectations of short-term rates and foster lower longer-term rates.Second, the Fed should commit to keeping its federal funds rate at or below the current 1¼ per cent until core inflation climbs back to, say, 2 per cent or higher on a year-on-year basis. The current reading of about 1½ per cent (on Mr Greenspan's preferred measure, the core PCE deflator) is right in the middle of the 1-2 per cent range that Ben Bernanke, Fed governor, recently suggested as the working definition of price stability.
A commitment to a higher inflation rate would be better than a commitment to eschew tightening for a specific period, as some have suggested.Under the former, if the economy strengthened or if inflation rose, expectations about when the Fed would be released from its commitment would move closer and investors would bring forward their expected date of tightening. Bond yields would rise even before the inflation target was reached, helping to slow the economy and keep inflation from rising. Conversely, if the economy slowed or inflation fell, investors would anticipate a much longer period of low short-term rates. This would pull down bond yields, helping to stimulate the economy. The bond market vigilantes would be enlisted as a posse to help the Fed stimulate or restrain the economy.
In contrast, a time commitment could backfire. If the economy were much stronger than expected and inflation climbed, Fed officials would be stuck with a Hobson's choice - honour the commitment and allow inflation to climb higher than desired or renege on it and lose years of hard-won credibility.A strategy tied to an objective of modestly higher inflation does not require an accurate forecast. The Fed just has to be willing to live with inflation as high as the target. But what about the danger of an economy with a head of steam overshooting the inflation target? After all, given the slow effect of monetary policy, it would take time for the Fed to slow the economy. This is a risk. But we have little doubt that the market would start to raise longer-term interest rates, tightening long before the Fed. Meanwhile, the Fed would restore a buffer of inflation against a deflationary shock.
Such a strategy would require Mr Greenspan to give up some of his cherished flexibility. But flexibility is not always a good thing. It leads to uncertainty, not least over the Fed's vigilance in avoiding deflation. Such uncertainly contributes to higher risk premiums for both corporate equities and bonds. By reducing worries about deflation, the Fed could restore more normal risk premiums, promoting a greater appetite for risk among investors in post-bubble corporate America.Expectations are what drive markets. By shaping expectations - and anchoring inflation expectations in positive territory with a buffer against deflation - the Fed could get the more exuberant economic recovery it desires, with less risk of deflation.
Source: Financial Times
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