The Fed should be worried about runaway inflation—but don't forget the Zero Lower Bound
US inflation shot up by 6.2% year-on-year and 0.9% month-on-month in October, overshooting market expectations to reach the highest increase in prices in more than 30 years.1 This has President Biden in hot water with Republicans and several economists and has the potential to damage the Democrats electorally before next year’s crucial midterms.
Up until a year ago, according to standard monetary policy rules such as the Taylor rule, the US Federal Reserve would now be “behind the curve”—given current high levels of core inflation and low unemployment, the Fed funds rate should be higher than it currently is.2
But in August last year, the Fed launched a major overhaul of its monetary policy framework, changing tack to a “flexible average inflation targeting” (FAIT, not FATE!) regime.3 Before, past inflation was irrelevant to the Fed’s decision-making; what mattered was present and future inflation. But now the Fed cares about inflation in the past as well. Specifically, Fed monetary policy will be such that inflation equals 2% on average. If inflation has been below target in the last few years, then the Fed will allow inflation to exceed target until, on average, inflation hits its target.
Seem counter intuitive to you? You’re not the only one—Colombia University professor Willem Buiter, writing recently in the FT, agrees, saying that FAIT is “economically illiterate”.4 Indeed, “why should unintended and mostly unavoidable inflation targeting failures in the past justify future deliberate failures?” he harrumpfs.
Buiter’s comment would be irrefutably on the money—in a world without physical cash. That is, in a world without a Zero Lower Bound (ZLB).
The neutral rate of interest—the real interest rate which is consistent with with the economy running at its potential without increasing inflation, otherwise known as r*—has been falling markedly in the last few decades.
According to calculations using the much-used Laubach-Williams model, r* was hovering below 1 just before this terrible pandemic hit.5 Let’s say r* = 1%.
The real interest rate (r) is equal to the nominal interest rate (i) minus inflation (π). The Fed’s inflation target is 2%. Therefore, in order to have a real interest rate which is equal to r* and consistent with the inflation target, the nominal interest rate—the Fed funds rate—would have to be equal to 3% (in maths: π* = 2%; r = i - π*. If we require that r = r* = 1% —> i = 3%).
That gives very little space for the Fed to hammer down the monetary policy lever in times of adverse demand shocks (such as that which occurred with the pandemic), especially if you compare it with the r*-and-inflation-target-compatible Fed funds rate of ~6% in the 1990s.6
This brings me on to the explanation of why Buiter’s argument is flawed.
Let’s say the U.S. is struck by a big demand shock, with the nominal rate at just 3%. Then it may be that the Fed needs to reduce the nominal interest rate to, say, -2%.
But it can’t. Why? Because, as I said earlier, physical cash exists. People can withdraw money from banks and store the money somewhere else, avoiding the negative returns which would arise from negative nominal rates. This is the Zero Lower Bound (ZLB) on nominal interest rates.
What does this have to do with FAIT, you might ask. The ZLB will still exist regardless, you might say.
Very true. Very, very true. But let’s introduce the key villain to this nail-biting narrative: inflation expectations. That’s right. Ultimately, for monetary policy, what matters isn’t so much current inflation, but what people think will happen to inflation in the medium-run.7 That’s why observers are greatly concerned that current high inflation seems to be causing a gradual upwards shift in inflation expectations.8 The Fed has gone “all-in” on its bet that inflation is transitory. But if it isn’t, inflation expectations risk becoming deanchored—that is, they risk running a wage-price spiral and resultingly huge inflation, as happened in the 60s and 70s.9
But it’s ironic that we now face this problem of too high inflation expectations—and this irony seems to be (conveniently) lost on many in the political world and the media.10 Before the pandemic, the concern was that inflation expectations would become too low—if the Fed is unable to inject sufficient monetary stimulus into the economy to help it reach 2% inflation consistently, due to the ZLB, and yet it still promises to raise rates if inflation is set to exceed 2% (and can do so, as there is no “upper” bound on nominal interest rates), then inflation will be below 2% on average—as it was between the Great Financial Crisis and the pandemic—and economic agents will begin to expect that inflation remains below 2% on average in the medium-run, making below-target inflation persistent: a self-fulfilling prophecy.11
The nice thing about FAIT is that it allows for overshooting of the inflation target, which can compensate for below-target inflation figures that occur because of the ZLB. Thus, on average, inflation will remain on average 2% in the medium-run, which economic agents will incorporate into their expectations. That is, inflation expectations will be anchored at the goldilocks level of 2%.
FAIT also has some other nice properties—it can allow the economy to run hotter for longer, meaning the gains from an economic recovery are more widespread: in particular, research shows that the gap between Non-Hispanic white and African American/Hispanic unemployment rates narrows the further into a recovery an economy reaches.12
Nonetheless, many have vociferously argued against FAIT, not least Professor Buiter. Even if the ZLB is binding, the Fed has other monetary policy tools available to it, such as quantitative easing or forward guidance. But the efficacy of such instruments is debateable and they have potentially adverse secondary macro effects.13
That said, certainly, the fact that the time window for the moving average of inflation—and the Fed’s exact weighting on labour market outcomes vs. inflation—is not well defined is problematic, allowing it too much wiggle-room and potentially undermining its credibility. And if the Fed’s all-in bet on inflation being transitory is wrong, the consequences could be dire for the world economy, and the Fed could lose a great deal of its credibility in the process, making it much harder for it to anchor inflation expectations in future.14
Concerns about a de-anchoring of inflation expectations are valid, especially as it now appears less and less likely that current high inflation is only transitory, but let’s not forget that, not too long ago, the concern was that inflation would be stuck at too low levels.
Imagine if the Fed ditched its FAIT framework and switched back to its old regime, and inflation pressures subside. What happens if the factors which have driven a fall in r*—ageing populations, rising inequality, globalisation—continue to drive the neutral interest rate down or simply keep it low? The Fed will have already lost a great deal of its credibility, having already switched monetary policy regimes once because it felt it switching strategies originally was a mistake. In this case, the Fed would risk being stuck for greater amounts of time at the ZLB. The Fed would then be left with two options: 1) keep its monetary policy regime, and risk consistently below-target inflation; or 2) switch back to a FAIT regime and risk losing even more credibility. A deanchoring of inflation expectations isn’t a pretty prospect, but then again neither of the two above options are, either.
Media coverage:
Fed should ditch AIT - https://www.ft.com/content/57e61776-bef9-4f8d-943e-d2678e921145
Recent FT big read on inflation & monetary policy - https://www.ft.com/content/570e9180-45fb-4157-9727-553c2471c309
Martin Wolf’s alarm regarding October inflation figures - https://www.ft.com/content/dc3bedc7-5694-4868-8b86-f9a215966f52
Summers in Bloomberg - https://www.bloomberg.com/markets/fixed-income?sref=wMkMsFyz
More Bloomberg - https://www.bloomberg.com/businessweek?sref=wMkMsFyz
Niall Ferguson in Bloomberg - https://www.bloomberg.com/future-of-work?sref=wMkMsFyz
WSJ Editorial - https://www.wsj.com/articles/biden-and-the-jerome-powell-inflation-lael-brainard-federal-reserve-11637613794?mod=hp_opin_pos_3
Mentioned in Powell’s speech, see the 3rd citation
QE seems to be effective in loosening financial conditions…
https://www.nber.org/system/files/working_papers/w25123/w25123.pdf
https://papers.ssrn.com/sol3/papers.cfm?abstract_id=2858204
…but may increase inequality, risk undermining central bank independence (since CB purchases lower government yields)
inequality: https://peri.umass.edu/media/k2/attachments/WP407.pdf
financial instability: https://www.nber.org/papers/w22285 or https://www.econstor.eu/handle/10419/165969