Scott Sumner  

Kocherlakota on the inflation outlook

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Matthew Boesler has a very nice piece in Bloomberg discussing the market reaction to several recent pieces of news. You should read the whole article (it's short) because it's hard to excerpt. The most interesting takeaway is that the market's inflation risk premium fell early in the day on higher than expected inflation data, and then rose on Fed comments suggesting that they were becoming less confident that inflation would soon rise to 2%.

Does that sound strange? Boesler suggests that the markets thought the higher than expected CPI numbers might lead the Fed to tighten, thus reducing inflation later, and the later dovish comments by the Fed suggest easier money going forward, leading to higher future inflation.

Boesler also suggests that the Fed is likely to continue undershooting its 2% inflation target, as it's done for most of the past 7 years:

Even more surprising was their forecast for where inflation would be by the end of 2017, which they downgraded despite the recent pickup in price pressures. The median of the 17 Fed officials who sit on the Federal Open Market Committee saw inflation -- defined as the year-over-year change in the price index of personal consumption expenditures excluding food and energy -- ending next year at 1.8 percent. That's only a tenth of a percent higher than where it was in January of this year.
Also at Bloomberg, former Minneapolis Fed President Narayana Kocherlakota suggests that the real problem is not that central banks are out of ammo, but that they are intentionally trying to undershoot the official 2% inflation target:
What's surprising is that -- judging from the latest projections -- more than half of the participants are comfortable with inflation remaining below the Fed's 2 percent target for another two years, and at least four are OK with missing the target through 2018. That's highly unusual, given that many central banks around the world systematically aim to return inflation to their targets within two years (see page 4 of this letter from the Bank of England for an example of what I mean).

U.S. inflation has been below target for nearly four years. This outcome is sometimes viewed as a sign of monetary policy impotence. But the Fed's projections tell us that many, if not most, officials are actually aiming to keep inflation below target for an extended period of time. In other words, low inflation in the U.S. reflects a lack of will, not tools.

Here I'm tempted to do something very strange, defend the Fed against a former top Fed official. I actually agree with everything that Kocherlakota says, but I'm not 100% sure that the intentional undershoot is all that important. It's only a couple tenths of a percent. I'm much more worried that the Fed has no good strategy to address the next recession, and/or the next episode of the zero bound. And yet . . .

When considering the fact that inflation is expected to run only a few tenths below target, keep in mind that both the Fed and private forecasters have tended to overestimate inflation in recent years. Market forecasts have tended to run lower, although those may have biases as well. In the end I think Kocherlakota's criticism should be taken seriously, because the one thing we've learned over the past decade is that at the zero bound, dovish credibility is much harder to achieve (using their current instruments) than hawkish credibility. Central banks that have targets of "below, but close to 2%", really ought to change them to "above, but close to 2%". In other words, I'd much rather be in the position of the Reserve Bank of Australia than the ECB. I'm still much more concerned by the downside risks than the upside risk of high inflation, even as I concede the Fed may be pretty close to its target in two years. Best of all, central banks could switch to NGDP level targeting, which would dramatically reduce downside risks, even with low average inflation rates.

PS. As an aside, there is a lot of unfortunate confusion about the recent inflation data. The Fed targets PCE inflation, which has been running below 2% and is expected to continue doing so (although the next few months may be a bit higher). But the newspapers focus on CPI inflation. That's also been running below 2%, but the more predictive core CPI numbers just came in at 2.3%, year over year. Thus some people might be under the mistaken impression that we are already overshooting the Fed's inflation target. Not so.

HT: BC and SG

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COMMENTS (6 to date)
marcus nunes writes:

What is interesting is that the Fed never perceives itself as being responsible for "too high" or "too low" inflation! It´s always something else...

Philip George writes:

Japan's central bank has kept interest rates close to zero for decades and inflation too has remained close to zero all through that time. The Fed raised the Fund Rate in December 2015, and contrary to most predictions the inflation rate has actually risen.

That is not an accident. As the graph on shows, whenever interest rates are raised from very low levels inflation has risen in response.

The reason is that very low interest rates favour the financial sector by making leverage very cheap. When interest rates are raised, money moves from the financial sector to the real economy. So the real economy gets a temporary boost.

Scott Sumner writes:

Philip, You are confusing cause and effect--the higher inflation in the US (compared to Japan) is causing the higher interest rates.

The Fed raised the interest rate on reserves, which is contractionary.

tyler writes:

I came across this quote from Stanley Fischer in a Bloomberg article I was reading recently: "… a persistent large overshoot of our employment mandate would risk an undesirable rise in inflation that might require a relatively abrupt policy tightening, which could inadvertently push the economy into recession. Monetary policy should aim to avoid such risks and keep the expansion on a sustainable track."

So Fischer is arguing that the Fed might have to cause a recession if inflation gets a little too high? Isn't that better than causing a recession sooner by raising rates too quickly when inflation is already below target? It just seems Fischer is doing mental gymnastics to argue for higher interest rates NOW...and he's not very convincing. Your thoughts?

tyler writes:

Here's the link to the article I was referencing btw:

I'm only an economics undergraduate student, so maybe I'm not the best one to evaluate a Fed Governor's statements, but the logic of Fischer's argument seems pretty flimsy. And yet I've heard he's 'extremely well-respected'. Although that was from Bernanke, who is nice to pretty much everyone.

Scott Sumner writes:

Tyler, Fischer is a very talented economist. His logic is fine but I disagree with his assumption that higher inflation is a serious risk. The markets don't agree, and neither do I.

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