Brief thoughts on inflation targeting, the elusive benefits of price stability, and much more

Here is an except from Matthew Klein's excellent post The Fed's grudging embrace of inflation targeting, part 1:

Yellen also thought there wouldn’t be any to actually achieving price stability, as opposed to continuing along with slow and steady consumer price inflation: 

"We have excellent evidence that the one-time cost of lowering inflation is high. Each percentage point reduction in inflation costs on the order of 4.4 percent of gross domestic product, which is about $300 billion, and entails about 2.2 percentage-point-years of unemployment in excess of the natural rate. If we testify, it seems to me that we should point out that the benefits of price stability are elusive and that the costs of additional output instability with such a plan could easily outweigh the benefits of greater inflation stability. 

Why? Because uncertainty about sales impedes business planning and could harm capital formation just as much as uncertainty about inflation can create uncertainty about relative prices and harm business planning…It remains exceptionally difficult to uncover clear-cut evidence that moderate rates of inflation reduce perceptibly the growth or level of measured GDP." 

Yellen, and the other opponents of a hard inflation target, preferred to tether Fed policy to something either resembling Taylor’s rule, or, in the words of Fed governor Larry Lindsey, “our target should be nominal GDP.” In other words, find a way to balance the alleged trade-off between growth and inflation rather than focus solely on one variable. 

In our next post, we’ll focus on how the debate in 2009 and what it tells us about the meaning of the explicit numerical goal articulated in 2012.

The Yellen quote above derives from comments she made in 1995.  Of particular interest is her thinking on business planning.  Businesses must plan using assumptions which incorporate their expectations having to do with future sales relative to costs (among other things).  As Yellen implies, uncertainty on sales wreaks havoc on business planning, harming their ability to properly spend on capital formation or other investments.  This risks reducing capital expenditure or can result in what in hindsight will look like wasteful "irrational" investment.  Furthermore, if capital expenditure does turn out to be wasteful as future sales do indeed fail to meet expectations especially where businesses issued debt to fund this investment spending, then the risks of financial instability concerns arise if the use of private leverage is widespread enough. 

As Yellen states, businesses individually and in aggregate face uncertainty having have to do with the relative price of their goods compared with input costs.  However price is only one variable, the other being output (quantity) sold, both of which in combination determine total gross nominal revenues/sales.  By instituting an inflation target, the idea in part is to stabilize expectations centered around the path of future prices for goods and services produced domestically and therefore fixing one of the two variables.  As the rate of growth of the price level is tightly managed, aggregate quantity produced is forced to make the bulk of the adjustment when economic conditions change. 

Fed policy does this by stating an explicit inflation target and then using their array of monetary policy tools to hit that objective.  Moreover if market participants believe that the Fed policy is credible, then they should work to reprice financial asset values to incorporate the eventuality of Fed tightening as inflation is about to approach or temporarily surpass the target or target range.  In essence market participants front run the Fed and in doing so tighten financial conditions before the Fed does in part by bidding up interest rates along the yield curve.  Bernanke alludes to this in his inaugural blog post:

"When I was at the Federal Reserve, I occasionally observed that monetary policy is 98 percent talk and only two percent action. The ability to shape market expectations of future policy through public statements is one of the most powerful tools the Fed has."

Therefore, if the path of inflation is understood to be above target, the repricing of assets will work to dampen aggregate demand with the expectation that the Fed stands ready to act if this adjustment does not occur.  If this adjustment is successful, expected inflation remains anchored while the future path of output, employment, and spending/income/nominal GDP growth are expected to come in lower than they otherwise would have been.

Businesses and households in aggregate may receive the benefit of price stability when planning present and future investment and consumption expenditure, but this comes with the aforementioned costs.  If markets expect the Fed to credibly react to inflation above target, businesses and households face greater uncertainty associated with the future path of interest rates, unemployment, output, income, and spending growth all of which influence expectations of future business sales.  In a roundabout way, Fed policy that is overly reactive to the price stability part of their mandate risks fueling the very uncertainty that their polices are supposed to ameliorate.

With all that said, market prices particularly interest and FX rates do not necessarily imply that the Fed will even hit their inflation target anytime soon.  This shouldn't be much of surprise as they have undershot the target for over three years.  One would also need to consider where the price level, employment, and NGDP growth would have been had the Fed been successful in doing so.

As the Fed has been advertising the possibility of a rate tightening cycle and it's potential path, the markets have reacted by bidding up short term interest rates.  Seeing as the ECB, BOJ, and a plethora of EM central banks have reacted to weak aggregate demand by loosened their policy stance during this time, the markets have aggressively bid up dollar FX rates since July 2014.  Despite persistently low inflation, sluggish corporate earnings growth coupled with widening credit spreads, stagnant median wages, and at best a relatively respectable unemployment rate which still seems quite high given the drastic decline in labor force participation, an argument could be made that the Fed is setting expectations in the wrong direction.  It's hard to say whether long term treasury bond rates suggest this as well given that QE, bank regulatory restrictions, and global demand for safe dollar assets all work to depress treasury yields.

Then again, bank regulatory restrictions work to reduce excess private leverage while global demand for safe assets derive partially from a desire by foreign governments and central banks to accumulate dollar reserve assets to manage their FX rate rather than using these financial balances to boost aggregate demand in their respective domestic economies.  Both of these conditions depress global aggregate demand relative to supply thereby leading to the low level of long term rates witnessed not only in the US but in the majority of the developed economies.  So in light of this, perhaps low long term treasury rates do suggest that markets don't expect that the Fed will or even has the ability to do whatever it takes anytime soon to boost domestic demand enough to offset global weakness.*  Therefore, the Fed could be in the process of overestimating future domestic economic growth and inflation.  More interestingly, the Fed's public deliberations could be putting their own economic forecast at risk.  Hopefully their projections prove accurate this time around but if the recent batch of soft economic data is any indication, the Fed's expectations may prove to be too optimistic.  That still remains to be seen.

*In a recent address at the Center on Budget and Policy Priorities forum, Bernanke points out that policymakers have been over relying on monetary policy relative to fiscal policy when attempting to address the current sluggishness in domestic and global growth.  Larry Summers has also expressed this point as well when stating that a more balanced policy mix could produce faster and healthier economic growth at a given level of presumably higher interest rates.  Bernanke acknowledges this but also stresses that it's likely not politically possible to use fiscal policy on an ongoing basis to maintain a sufficient growth rate of aggregate domestic demand to ensure full employment.  

He explains that governments which influence global trade and capital flows by continuously accumulating net foreign reserves are pursuing national policies that purposely restrains their domestic demand and impairs global economic activity in the process.  Seeing as how Chinese policy is attempting to safely transition away from such an FX regime that at least indirectly suppresses labor share of income and imports in order to boost net exports, Germany is now the greatest offender.

Bernanke explicitly notes how Germany is able to take advantage of having an undervalued currency relative to its Eurozone trading partners within the Eurozone's fixed exchange rate regime.  At the expense of the rest of the Eurozone, this enables Germany to maintain full employment and price stability despite persistently weak domestic demand.  To make matters worse, Germany's unwillingness to boost domestic investment and consumption while also blocking joint Eurozone investment spending results in elevated unemployment and depressed economic activity throughout the rest of the Eurozone especially the periphery. This is even more problematic given that expansionary fiscal policy is heavily restricted at the individual national level as a result of the Maastricht Treaty specifically the Stability and Growth Pact.  Thus, the burden of adjustment falls on the high unemployment areas having to reduce regulatory and labor costs (wages) which reinforces the weak demand impulse as well as brings about the potential for financial instability.  As a result the ECB has been forced to respond by easing monetary policy in however which way they legally can (QE, negative interest rate policy, both leading to currency depreciation).  All of this has the effect of reducing the Eurozone's demand for foreign imports particularly as the periphery economies are forced to cut back.  Consequently, a rebalancing of the global economy and the restoration of both US and global aggregate demand, full employment, capital utilization, and more "normal" global interest rates require that countries in the developed world, specifically in the Eurozone, stop engaging in such wasteful policies that elevate price stability and fiscal prudence above all other economic objectives.