How Low Can You Go: Monetary Policy Constraints And Options For The Next Recession

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Yield curve control

  • A higher inflation target is a wonky-but-potential response to the effective lower bound on rates. The premise is that if nominal interest rates are constrained by zero, a central bank can push real interest rates deeper into negative territory if future inflation is expected to be higher. The problem with this proposal is twofold: First of all, in the United States, selling this to Congress would likely prove an uphill battle. Secondly and more importantly, with most central banks undershooting their inflation targets presently, raising those targets would likely lack credibility. And if inflation expectations did not rise, the announcement would prove useless. This is particularly true if the central bank were to try such a strategy during a recession, when the output gap was large and disinflationary pressures were at their strongest. 
  • Price level targeting and what are more broadly known as inflation make-up strategies appear to be an early front runner in the Fed’s policy review. The premise is that a central banker should not only be satisfied that inflation is currently running at 2%, but he or she should be committed to allowing temporary inflation overshoots to make up for past undershoots of the target. In effect, the goal is to achieve 2% inflation over the business cycle. 

    One of the worries in the market has been that the Fed and other central banks would snuff out the expansion as soon as inflation threatens 2%. After years of misses—and with such a strategy likely contributing to the next recession—markets can and have reasonably priced average future inflation of slightly less than 2%. The Federal Reserve is concerned about this dynamic, given how important inflation expectations are in the price formation process. In other words, if everyone thinks inflation will likely be slightly less than 2% then it will probably turn out to be less than 2%. While this may sound like a small policy shift, the implications are actually very significant. For example, in the most recent Monetary Policy Report to Congress, the prescription from a price-level rule suggested the federal funds rate should be only 0.13% (versus the current policy setting of 2.4%). If the Fed adopted this framework, operationally it wouldn’t necessarily cut interest rates on a dime, but it could mean a much more protracted hold than what was shown in the latest dot plot. 

    This framework is theoretically attractive, but again suffers from credibility problems. For one, it’s easier to say you are going to allow inflation to overshoot when it is low today than it is for a future FOMC to keep rates accommodative when inflation is actually overshooting. The complexity of the rule is also a challenge: How do you communicate it to the public? And where do you calibrate the normal price level to historically? 

    The possibility of cycle-ending asset bubbles is another challenge. More careful attention needs to be dedicated to this topic, but it looks like a viable and popular tweak to the current framework. On a side note, this idea is gaining international traction as well. Mario Draghi’s recent speech in Sintra, Portugal, expressed tolerance for above 2% inflation in the region. It will be interesting to see if Christine Lagarde shares these views when she takes the helm of the ECB later this year.

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Price level rule

The above list of recession-fighting options is by no means exhaustive. I handed in my Fed security badge at the Eccles building in the Summer of 2009. A lot has changed since that time, and it’s entirely possible that other experimental methods are being discussed behind the closed doors at the Fed, the ECB or other central banks. But the bottom line is that the extraordinary monetary policy tools that were used to fight the GFC will be required again and should be judged as ordinary in a world of secularly lower interest rates. That means e all need to understand these tools and how they work. Tools like forward guidance and QE were considered the first-best options for delivering stimulus in the aftermath of the GFC, and these are likely to be the first ports of call when conditions sour again. To be clear, though, central banks are very low on ammo. And that means a heavier burden will be placed on fiscal policy in the next economic downturn—the topic of my next note.

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These views are subject to change at any time based upon market or other conditions and are current as of the date at the top of the page.

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