New Monetary Policy? FOMC Release

The FOMC press release is here.

On the bright side, the Fed is continuing with its  policy of open-ended open market operations.   Further it plans to include purchases of longer-term Treasuries as well as mortgage backed securities.   This at least moderates the degree of centralized credit allocation that was emphasized last month.

Second the Fed is continuing with its outcome-based approach, committing to continue with a low target interest rate until labor market conditions improve conditional on price stability.   It has now explained what those vague terms mean--unemployment no higher than 6.5% and inflation no higher than 2.5%.   

Unfortunately, the asset purchase (money creation) program has a very vague end point--when the recovery strengthens.   Consistent with its continued wrongheaded focus on interest rates, it is the target interest rate that will remain low until unemployment falls to 6.5% or inflation in the medium term rises above 2.5%.

Worse, the Fed insists that long run inflation expectations must remain 2 percent.   If we imagine that inflation suddenly jumps to 2.2% in 2014, it is certainly possible that inflation can be expected to be 2% from then on.   However, if inflation is currently 2% and people today expect a rapid recovery will be associated with slightly higher inflation--say 2.2% in 2014, then the only way they can expect inflation to be 2% over a longer time frame, say to 2017, would be for inflation to be below 2% some point after the recovery.    Is this some kind of commitment to a boom-bust cycle?

I suppose that if inflation is expected to be below 2% in the near future, this approach allows inflation to be above 2 percent in the medium term, averaging to 2% in the long term.   But where does that leave us when the medium term arrives and inflation is 2% (or more?)   Still looks like an expectations of disinflation at some future time.

As far as I can tell, all the 2.5% inflation rate in the medium term does is to allow for transitory supply shocks.   If, for example, trouble in the Persian gulf leads to higher oil prices and a higher CEP in 2013, but after the war is over, oil prices will drop again, and so the CEP will either drop or grow more moderately for a time, the inflation rate over a short time horizon would rise, without it rising over a longer horizon.

As far as I can tell, this formulation is not consistent with a return of the price level to its previous growth path.   If the price level is below its growth path, catching up with it implies a more rapid inflation rate over all horizons (short of infinity?)

Of course, I think allowing for more "flexibility" in dealing with transitory supply shocks is a good thing.   I would hate to see the Fed tighten monetary policy in the face of a war scare in the Persian Gulf, citing worries about inflation expectations becoming unarmored.   I just don't see how this helps with recovery.

From a Market Monetarist perspective, the proper policy is to identify a target growth path for spending on output and then commit to set the quantity of base money at whatever level is necessary to reach it.   Under current conditions the relevant commitment would be to increase base money however much is necessary--$5 trillion, $10 trillion, whatever.   There should be no commitment regarding inflation, unemployment, or interest rates.   In particular, there should be no threat to call off the increase in spending on output if inflation rises above 2.5%.    That threat to call off the expansion of spending due to inflation reduces the motivation to spend on output now.

I think most Market Monetarists would consider the growth path of the Great Moderation to be an upper limit on what is appropriate.   In 2007, 2008, or 2009, most of us would have advocated returning nominal GDP to its previous growth path.   On the other hand, after four years, Sumner is proposing two years of 7 percent growth and then 5% in the future.   I favor a year of 10% nominal growth and then 3% in the future.

Anyway, it is conceivable that nominal GDP would reach the growth path of the Great Moderation, and inflation would be less than 2.5% and the unemployment rate above 6.5%.    If that were to occur, the Fed's policy would be too inflationary from a Market Monetarist perspective.    However, a more realistic expectation is that inflation will rise above 2.5% or else unemployment will fall below 6.5% before spending on output grows that amount.

I find the Fed's approach to shout "inflation-unemployment trade off."   If our effort to push down unemployment results excessively high inflation, then we will call it off.   But 2.5 percent inflation is acceptable if it causes a reduction in the excessively high unemployment rate.

The correct framing is that if real output is below potential, then the unemployment rate is above the natural unemployment rate.   More rapid growth in spending on output should result in growing sales, production, and employment.   This will raise output closer to potential and lower the unemployment rate closer to the natural unemployment rate.   Unfortunately, it might also cause more inflation.  If it does cause more inflation, we will put up with no more than 1/2 of a percent more inflation.   Further once output and employment grow enough so that the unemployment rate falls to 6.5 percent, no more than 1 percent beyond the natural unemployment rate, then we will put up with no extra inflation from added spending growth that might  bring output even closer to potential and the unemployment rate even closer to the natural unemployment rate.

If it turns out than real output is  at (or close to) potential, so the unemployment rate is approximately equal to the natural unemployment rate, then to the degree more rapid growth in spending on output causes real output and employment to grow, it will push output beyond potential and push the unemployment rate below the natural unemployment rate.   These changes in output and employment are likely to be transitory and the result will almost certainly be higher inflation.    We will cut this program off as soon as it leads to 1/2 of a percent more inflation.

The Market Monetary approach is that the policy should be to get spending on output to target.   If output is below potential and the unemployment rate is above the natural unemployment rate, then growing sales, production and employment should bring output closer to potential and the unemployment rate closer to the natural unemployment rate.   That is good.   It would likely be associated with higher inflation for a time, though once the target growth path is reached, the inflation rate will slow--to approximately 2% with a 5% nominal GDP target.   If output is at potential and the unemployment rate is at the natural unemployment rate, then there will be little increase in production or employment.   That any increase would be small is just fine, it is rather whatever small increases that occur are undesirable.   Sadly, in this situation, the increase in inflation would be greater.   While that is unfortunately, it is the least bad result.   When potential output is low or growing more slowly, the least bad alternative is for output prices to rise more rapidly rather than have nominal incomes (including wages) grow more slowly.