Shadow Open Market Committee Statement: Federal Reserve Policy Adrift
Statement in advance of SOMC Symposium on November 20th, 2012
The FOMC after its January 2012 meeting announced, for the first time, an explicit, quantitative target for inflation. Using words that echo Milton Friedman’s famous dictum that “inflation is always and everywhere a monetary phenomenon,” the FOMC acknowledged publicly that “the inflation rate over the longer-run is determined primarily by monetary policy, hence, the Committee has the ability to specify a longer-run goal for inflation.” Indeed, the FOMC’s announced goal, if taken seriously, would seem to leave no room for ambiguity: the January 2012 statement points explicitly to a 2 percent objective for PCE inflation as the one that is “most consistent” with the Fed’s statutory mandate.
With the announcement of its inflation target, FOMC members gave themselves and the American people a valuable tool for evaluating Federal Reserve policy actions, inviting all observers to ask the same question that Milton Friedman would: do these actions contribute, or do they not, to the stabilization of inflation around the 2 percent target? Out of the myriad of new programs and initiatives the Fed has introduced since 2008, therefore, this announcement of an inflation target stands out in terms of its ability to re-anchor monetary policymaking and our expectations for the future.
This promise makes it all the more surprising and disappointing that the FOMC chose to present its latest round of policy actions with direct reference not to inflation, but to unemployment instead. On September 13 the FOMC announced that it would begin to add $40 billion of reserves to the banking system every month by acquiring agency mortgage backed securities until the labor market improves substantially. To reinforce its policy accommodation the FOMC added that “a highly accommodative stance of monetary policy will remain appropriate for a considerable time after the economic recovery strengthens.” And all this stimulus comes after the Fed has generated $1.5 trillion of excess reserves.
Inflation appears as an afterthought in the September 13 policy statement. All the FOMC says in its statement is that it intends to continue its highly accommodative policy actions “in a context of price stability.” The Fed appears willing to tolerate higher inflation in an effort to facilitate a reduction in unemployment. The only way one can read these words is that the Fed plans to continue its highly accommodative monetary policy until inflation becomes a concern.
Why not adhere to its principles, reassure markets, and tie down inflation expectations firmly by reiterating its intention to target 2% inflation over the longer run? Failure to do so only months after its announcement undermines the credibility of the 2% inflation target, and defeats its professed purpose of anchoring inflation expectations to improve the flexibility of monetary policy to act against unemployment.
The market is left to wonder, how much inflation is the FOMC willing to accept and for how long? What is to be gained by matching open-ended reserve creation with an open-ended tolerance range for inflation and open-ended horizon over which a departure from 2% inflation would be tolerated? Might not that lack of clarity destabilize inflation expectations and facilitate the uncertainty so detrimental for employment? Simply put, didn’t Fed history discredit long ago the notion that monetary policy has the luxury of putting inflation concerns on hold so long as unemployment remains elevated?
Why is the FOMC unwilling to include bounds on its tolerance range for inflation in its policy statement? Does the Fed believe that monetary policy can only be effective against unemployment if inflation rises first, or that inflation must be allowed to rise after the fact for monetary policy to bring unemployment down? Even so, the Fed must recognize a tension between flexibility on inflation and the stabilization of inflation expectations that would call for some mention of bounds on its tolerance for inflation.
Perhaps the Fed believes that there is little risk of its highly accommodative policy causing inflation to rise if unemployment stays high. But in this case the Fed must believe that adding bank reserves indefinitely will have no inflationary consequences as long as unemployment remains elevated. Theory and history would again say otherwise.
Lack of clarity on inflation in the September 13 policy statement suggests that the Fed is willing to pursue highly accommodative monetary policy to bring unemployment down until inflation becomes the public’s concern. This is a trap. By the time that inflation becomes the public’s concern, pricing decisions will already embody rising inflation expectations. And the Fed may need to precipitate a recession with high interest rates to bring inflation and inflation expectations back down.
Rather than risk the above fate, the FOMC should put its January 2012 statement of principles to work. The FOMC should assert in its policy statements the 2% longer-run inflation objective. Moreover, the FOMC should discipline its monetary policy actions by including in its policy statements an explicit range and a horizon beyond which it would not wish to tolerate a departure from 2% inflation.
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