Good morning. After weeks of climbing higher, yields fell on Friday, setting off a relief rally in stocks. Suspects include dovish Fedspeak and erratic services activity data. Neither seems terribly durable to us. Higher for longer is the unmistakable drumbeat coming from the Fed.
Today, we look ahead to a choice the central bank may well face later this year, which has been attracting interest on Wall Street. Email us: robert.armstrong@ft.com and ethan.wu@ft.com.
Why the Fed might fudge
The Federal Reserve has pledged to keep inflation somewhere around 2 per cent. Here is one problem with that:
If inflation is largely unpredictable, and hence not finely controllable, then . . . the central bank could always argue that wide misses were the result of bad luck, not bad faith . . . This possible escape hatch for the central bank . . . suggests that building up credibility for its inflation-targeting framework could be a long and arduous process.
This, from a 1997 paper by Ben Bernanke and Frederic Mishkin, captures why there is so much hand-wringing anytime someone suggests the Fed ditch its 2 per cent inflation target. Central bank credibility — often defined as its ability to influence long-term interest rates through the short-term policy rate and strategic communication — is hard-won and easily lost. Changing the well-established 2 per cent target risks throwing years of hard-earned credibility away.
Might the Fed do it anyway? On that question, Jay Powell is very tight-lipped. But later this year, he could face an agonising choice between abandoning 2 per cent or engineering a recession. Inflation is an enigma, but as Don Rissmiller of Strategas has argued for months, history suggests it is symmetrical; it falls about as fast as it rises. This implies there is a long way to go, with mounting job losses along the way. It’s no large leap to imagine a scenario where inflation is falling but still above target, while unemployment is rising but not yet recessionary. The political pressure to loosen policy would be immense. The Fed might conclude raising its inflation target, or at least acting chill about enforcing it, is the best of a bad set of options.
On the merits, though, the case for a higher inflation target — perhaps 3 per cent — is strong. First, it lets prices adjust more flexibly. In general people like price cuts but hate wage cuts, an asymmetry that makes downturns more violent. Firms have to slow price growth but can’t do the same for wages, so they stop hiring instead. Research suggests running inflation a touch hotter gives prices more room to move, dampening the hit to employment and growth.
Second, and more importantly, a higher inflation target keeps rates further from the dreaded zero lower bound. At the ZLB, cutting rates doesn’t do much and the policy alternatives, such as quantitative easing, are messy and more poorly understood. Policy rates are set in nominal terms, but the larger policy stance (how tight or easy monetary policy is) depends on real rates, which in turn depends on inflation. Running inflation hotter would produce higher nominal rates for any given policy stance. That would give the Fed more room to lower nominal rates when it needs to.
Even critics of a higher target nod to this. They counter on different grounds. Maybe 2 per cent isn’t theoretically optimal, but moving to 3 per cent, especially now, would wreck Fed credibility. As Jonathan Pingle, chief US economist at UBS, put it to us:
If the central bank suddenly said, ‘OK, our inflation target is 2, we’re not meeting that target, so we’re gonna make the target 3’, then immediately the next question for most economic agents should be: ‘well, maybe they’ll turn around and make it 4’. And if they do that, maybe they’ll turn around and make it 5. That logic is a slippery slope . . . Once it starts to erode [it] creates real problems for the effectiveness of monetary policy.
Those problems might include long rates pricing in a big inflation risk premium the Fed can’t dislodge. Last year’s UK gilts crisis shows what can happen in the short run when policymakers lose credibility, notes Michael Metcalfe of State Street Global Markets. Nothing good. Even if something that extreme is unlikely, he thinks a “bond market buyers’ strike” can’t be ruled out.
Thundering into this discussion is Olivier Blanchard, the French economist who has for a decade (including in the FT last year) advocated a higher inflation target. Blanchard told Unhedged he thinks the case for a higher target is “overwhelming”. As an academic matter, few would dispute that. But in policymaking terms, too, he downplays the risks to credibility:
I think, in the right environment, a one-time goalpost move would be credible. There is no slippery slope here. It is clear that the earlier conclusions and computations that 2 per cent was the right target, and the probability of hitting the ZLB was small, were wrong. I think any reasonable economist, including [Harvard’s Kenneth Rogoff and Gramercy’s Mohamed El-Erian], agree about that.
I think there is zero risk of moving the target further and further. I heard the same argument about credibility when central banks started QE.
The point here is that context matters. Dropping anchor at 3 per cent — a still-low inflation rate that makes rate-setting easier in the long run — as the price of avoiding a recession wouldn’t mean the Fed has tossed out its inflation mandate. It means it’s weighing the balance of risks and picking the better option. As we like to say, it makes no sense to do stupid policy in the name of credibility.
However, Blanchard concedes that some credibility hit is likely. Rather than an inflammatory formal target change, he expects a Fed fudge:
When inflation is down to, say, 3 per cent, at some stage in, hopefully, the not too distant future, I am nearly sure the debate will be: Are we willing to further increase unemployment in order to get to 2 per cent, or should we revisit?
I suspect the debate will be muddled, central banks will not formally change their target, but will be more relaxed about getting to 2 per cent.
As Andy Haldane pointed out in the FT on Friday, a less aggressive attitude towards the speed of disinflation, once it is clear that policy is tight enough (not there yet!), is the Fed’s hidden policy tool. “They don’t talk about this as a lever,” adds Claudia Sahm, the former Fed economist now at Sahm Consulting. “But the reality is that it’s very fuzzy, and not by accident.” Some discretion over “when, and how fast, and how long” would help “take some pressure off of this 2 per cent vs 3 per cent” debate, she says.
But make no mistake: the Fed exercising discretion is a policy choice, carrying many of the same risks as an explicit target change. Sahm points out that before the pandemic, the central bank considered changing its target to 3 per cent, but declined to do so. The Fed likes 2 per cent inflation, in other words. Giving that up to avoid a recession would be defensible. But that decision feels precarious indeed.
One good read
In his widely read annual letter, Dan Wang on China’s lockdowns: “Weibo censored the first line of the national anthem: ‘Arise, you who refuse to be slaves.’”
Source: Economy - ft.com
