In the wake of the financial crisis, central banks were focused on the survival of the economy and financial markets, implementing near-zero (and sometimes subzero) interest rates and multiple rounds of bond buying (quantitative easing or QE). As conditions stabilized, however, the process became more focused on normalizing conditions and getting closer to pre-crisis levels in terms of policy and rates.
In the U.S., the Federal Reserve was eager to avoid overheating conditions due to late-business cycle government stimulus and to restore its policy flexibility. So, even in the absence of higher inflation, it began a tightening campaign that lasted from late 2015 until this past December and included both rate hikes and the partial unwinding of its bond positions (quantitative tightening or QT). In the wake of the fourth-quarter 2018 market swoon, the central bank moved into dovish mode amid trade tensions and slowing economic growth. Looking back, however, it appears that the Fed’s decision to normalize rates ahead of inflation put the cart before the horse, suppressing already weak core PCE (the central bank’s favored inflation measure) and leaving it below the central bank’s target of 2%.
Chairman Jerome Powell and his colleagues clearly understand that something isn’t working, and so they have organized a “Fed Listens” tour to take public comments on policy, followed by a period of private reassessment and potential changes early next year. Although this might seem like inside baseball to some, what the group decides could have major implications for the health of the economy and markets, so it’s worth investor attention. Below, I provide some high-level perspective on the key issues and proposals the Fed may consider as it seeks to get back on track.
Status Quo Infirmus
First, let’s take a quick look at the status quo. The central bank currently targets a specific level of inflation in its policies. When inflation is low and the economy is in the doldrums, it may cut interest rates to stimulate growth and bring inflation back to where it needs to be; when inflation is too high, it may do the reverse. The Fed ultimately seeks a neutral interest rate—low enough to stimulate the economy but high enough to avoid triggering excessive inflation—and is willing to go above or below the inflation target temporarily to achieve this.
However, inflation targeting is a difficult exercise. Former longtime Fed Chairman Alan Greenspan never actually attached a number publicly to the Fed target. The nominal objective was stable, relatively low inflation. But as part of efforts to improve transparency, his successor Ben Bernanke established the current numerical target of 2%. From the beginning, the Fed has been unable to hit that target, for example reaching an average of just 1.6% core PCE over the current business cycle, including the last five years.
Inflation has come in too low since the 2% goal was established.
Core PCE (%)
Source: Bloomberg. Data through April 2019.
A major part of the problem is structural. The global population is aging, limiting the growth of the workforce, while productivity growth—although somewhat improved recently—has generally been weak. The combination has tended to limit economic growth and, by extension, price inflation. In fact, inflation was in decline long before the financial crisis, falling from an average core PCE of 3.6% in the second half of the 1980s to 1.7% in the first half of the 2000s—something that made the Fed’s task of growth stimulation more difficult during the financial crisis. As a result, the Fed was forced to employ unorthodox policies such as asset purchases.
Another issue today is behavioral and tactical. The existence of a specific target number has made the market ultrasensitive to moves toward 2% due to the anticipation of Fed actions. This has virtually guaranteed that the target will never be reached on a sustained basis.
In order to get further away from the danger of actual deflation and to provide more policy flexibility, what options does the Fed have?
Raise the inflation target. In theory, it would be simple to keep the current approach but raise the inflation target, potentially to 3% or 4%. The notion is that this would allow for higher interest rates, and thus leave more room for the Fed to make cuts to bolster the economy in a downturn. However, the central bank is already having enough trouble getting inflation to 2%; and simply moving the target higher won’t necessarily achieve success or increase its credibility in the market. Another issue would be acceptance. The Fed’s mandate is to maintain price stability and maintain full employment, and some would argue that anything above 2% is higher than a neutral level. A possible variation would be to target a range, for example 1.5% to 3%, in order to help policy flexibility at any given time. However, that could foster too much uncertainty for investors and businesses.
Target an average. A more viable approach, to which some Fed members have already voiced approval, is average-inflation or price targeting. The current system takes what’s called a “bygones” view, in that it generally doesn’t consider where inflation has been in the past, but only where it should be in the future. In contrast, inflation averaging would take into account whether inflation had been below or above the target, and allow the Fed to employ policy to bring the average back into line with the target. This strategy would solve for the market’s sensitivity to a fixed number, as investors would expect inflation to over- or under-shoot as part of the process. For example, if you assume that the economy grows above potential 80% of the time and below potential 20% of the time, the inflation rate might be set at 2.4% during expansions in order to reach the overall average target of 2%.
The Inflation Gap
The Fed has a lot of ground to cover.
Source: Bloomberg. Data through April 2019.
Many observers are comfortable with the averaging approach at the moment because inflation has been subpar for years. But what happens if the Fed is successful in bringing the average back up and then inflation exceeds the target for longer? Will the public accept the hardship associated with higher rates to correct for past inflation? Will politicians? That seems like an implausible scenario to me.
Also, where do you start the measurement period for past inflation? Three years? Five years? It’s conceivable you could rig the system to overshoot the target for a decade or more, but that might open up the possibility of imbedding excessive inflation in the economy. Finally, what if a shock like a spike in oil prices were responsible for increased inflation? Would the central bank really want to take that into account in setting future policy?
Reflate opportunistically. During the pre-crisis decline of interest rates and inflation, the Fed applied what has been called “opportunistic disinflation”—stepping in early during recoveries with rate hikes in order to limit any rebound of inflation. Moving forward, the Fed might consider the corollary, “opportunistic reflation,” which would tolerate price increases due to late-cycle factors like a tight labor market or commodity shocks in order to bring the inflation trend back to more acceptable levels. An opportunistic approach could work in combination with targeting an average.
Target GDP. Another conceivable choice is to target the growth rate or the level of nominal GDP (including inflation as opposed to real GDP, which excludes it). Let’s assume that the Fed set target GDP growth at 4%. If it dipped below that amount, the central bank would ease monetary conditions until GDP came back to target; if it went above that level, the Fed would tighten correspondingly. This arrangement would simplify the task of the Fed, as it would only have to deal with one target (GDP) instead of the current two (inflation and employment). Nominal GDP is said to be easier to track than the various inputs the Fed currently has to monitor, and generally would result in similar rate trends as today—reductions in times of economic weakness and increases when times are good.
However, what happens if economic growth is sluggish for a long period, but inflation is also elevated, such as in the 1970s? The public might grow impatient. Also, this approach has a drawback similar to inflation targeting: A period after excessive GDP growth would require targeting lower growth later, with higher rates impeding economic activity and causing hardship. Finally, GDP numbers operate with a substantial lag, with final results often posted months after a given quarter and then reset a few years later. This likely would make GDP an unreliable basis for policy decisions.
Mix fiscal and monetary policy. Fiscal policy isn’t the purview of the Fed, but it makes sense to talk about the coordination of fiscal and monetary action in light of broader political debates.
An extreme theory known as Modern Monetary Theory (MMT) is providing theoretical cover for massive spending proposals such as Medicare for All and the Green New Deal. The idea is that countries that can print their own money can never default, and should therefore have no trouble using debt to pay for social programs. Congress would spend whatever it needs and then raise taxes to curb potentially inflationary effects of large deficits. Conceivably, the latter task could be outsourced to a politically insulated policy agency.
However, MMT is an untested idea with clear potential downsides. Higher and higher deficits would be hard to offset with economically stifling tax increases. And governmental control of capital could dampen the innate benefits of our free-market system, including growing productivity and higher standards of living. Printing money isn’t exactly a path to prosperity, as students of Weimar Germany will tell you.
That said, the idea of hitting fiscal and monetary levers at once is actually quite appealing. In the next downturn, it potentially could provide broader impacts than the “top-10% focused” remedies since the 2008 financial crisis. However, fiscal expansion needs to occur at appropriate times, perhaps earlier in a growth cycle than was the case with the 2017 tax cuts, which coincided with an acceleration of Fed tightening. From a practical perspective, it is unlikely that Congress would outsource a core legislative responsibility to (yet another) semi-accountable agency in the executive branch. So, progress will likely need to emerge from recognition of the value of tactical fiscal action—along with a more cooperative environment in Washington, DC.
Benefits of Flexibility
Although review is healthy, readers should take the Federal Reserve’s listening tour with a grain of salt. The Fed gets introspective every five years or so, and remains a slow-moving institution. So, I would expect “evolution, not revolution,” as Fed Vice Chairman Richard Clarida has put it.
With that caveat, I do think that some version of inflation-averaging, along with opportunistic reflation, makes sense. It would reduce the market’s tendency to anticipate the 2% boundary and, in the end, hopefully provide more room for the Fed to act during a crisis. What period you use to calculate the inflation average is a question, but looking at a full business cycle makes intuitive sense to me.
More than a change in formula, however, I believe the Fed needs to commit to flexibility—to constantly observe the economy and markets, and recalibrate as necessary.
Historically, economic monitoring worked at a snail’s pace—it just took a long time to gather and analyze data. As a result, the lag in Fed policy was enormous; by the time the yield curve was flashing inflation risks (by inverting, with short yields higher than long yields), the Fed was often a couple years in the hole in terms of needed rate cuts. Today, the central bank’s models are much better, and it conceivably can reassess policy almost in real time. This means that the Fed can keep rates closer to where they should be on an ongoing basis.
As part of this, of course, the Fed needs to look at the right data. Many of its legacy tools were born in the industrial era, but manufacturing prices have been in decline for a couple decades, and today about two-thirds of disinflation is likely happening due to artificial intelligence and the broader “Uber-ization” of the economy. Just looking at high-level indicators like CPI won’t tell you what’s really going on.
Paying Attention to the Market
Finally, the Fed must pay close attention to the market—something it got away from before the investors revolted in the fourth quarter. The yield curve has long been a popular signal for the economy, but has changed a great deal. Over the past decade, macroeconomic volatility has declined with GDP growth trends, which in turn has reduced the volatility of inflation—and lowered the premium investors demand for longer-term bonds. This has contributed to a flattening of the yield curve and increased the likelihood that it could invert. As a result, a short-term inversion doesn’t necessarily indicate looming recession, but a more extended inversion could. The Fed needs to take the shape of the curve seriously, along with what it may be saying about market sentiment.
At this stage, we believe the Fed has a good chance of making midcourse adjustments and engineering an economic soft landing, potentially extending the current record-long business cycle for a couple years or more. Along the way, giving the economy more leeway to expand above the target, and “taking a breath” before becoming overly hawkish could help Powell & Co. bring recalcitrant inflation back into line. This in turn could improve chances that the next economic downturn, whenever it occurs, is followed by healthy V-shaped bounce, aided by timely and effective monetary policy.