We Just Had the Lowest Core Inflation in 50 Years. What Does This Mean for "Expectations" and Monetary Policy?

Jun 5, 2013Mike Konczal

Last Friday, the BEA announced the lowest year-over-year rise in core inflation it has ever recorded. The year-over-year PCE core inflation, or inflation stripped of volatile energy and food prices, was 1.05 percent. As Doug Short notes, the previous all-time low was 1.06, and that is from March 1963. (The records go back to 1959.) Inflation is collapsing in 2013, both for observed values and future expectations. This is noteworthy because, as you may remember, the Federal Reserve took extraordinary actions at the end of last year to hit its inflation target.

Let’s put up a chart from Doug Short:

I had mentioned falling inflation in my Bernanke versus austerity column, but wanted a bit more core information before I flagged it. It’s now here. This is a major issue that isn’t being discussed. It gets to the heart of whether or not the Federal Reserve can manage the economy at the zero lower bound of interest rates through expectations, guidance, and purchases, which is a central issue now and for the future of economic policy.

It’s also worth discussing because the idea that the Fed has a lot of room is expanding into new ranks via conservative reformers. Josh Barro, now at Business Insider, just argued that “market monetarism is the shining success of the conservative reform movement.” Crucially, it is being used by thinkers on the right to justify ignoring fiscal stimulus. Ross Douthat just wrote that reform conservatives believe that “monetary policy [is] an alternative...to further fiscal stimulus,” and Brink Lindsey also mentioned being pro-monetary policy but anti-fiscal stimulus at a recent Roosevelt Institute conference.

Market monetarists can mean a range of things, from the generic observation that the Fed could be “doing more” to the idea of tying our monetary policy to a nonexistent futures market. But the idea that the Federal Reserve can be effective at the zero lower bound by setting expectations of future policies through commitments is an important part of the equation.

As David Becksworth noted (discussing a nominal GDP target, but still applicable to an inflation target), “[k]nowing that the Fed would be willing to buy up trillion of dollars of assets if necessary to hit its target would cause the market itself to do much of the heavy lifting.” And that’s what the Federal Reserve did last year.

Bernanke made clear he was going for 2 percent inflation at the beginning of last year. Instead of pegging low rates to future dates, he tied them to economic conditions, like unemployment being above 6.5 percent and inflation being lower than 2.5 percent. The higher ceiling made sure that inflation could go above 2 percent without tightening. And he then backed that up with new open-ended purchases set to those conditions. The Fed committed to purchasing a lot of assets until unemployment or inflation hit a limit or until they hit their inflation target - and so far inflation has done the exact opposite of what a reasonable person would have expected.

(It’s likely that the Federal Reserve’s actions are working through giving everyone ultra-low mortgage rates. That is boosting the housing market by encouraging new homes, bidding up the value of existing homes, and allowing aggressive refinancing. But, as far as I understand it, this is far away from the expectations channel that most ZLB monetary policy people reference. Indeed government actions like FHA backstopping the market, or HARP 2.0 ignoring the legal underwriting of reps and warranties on underwater refis, are big pieces of this story.)

Maybe everything will change and inflation will increase, but for now what should we conclude? First, the move to lock in 4 trillion dollars in deficit reduction was premature and is putting the recovery at serious risk. But perhaps the problem is that Bernanke is still too timid, and that a “regime change” is needed to wake up the financial markets. A move to 4 percent inflation would force the markets to act.

Whether or not you thought that the moves put into place would necessarily get inflation to 2 percent, certainly they should have provided a floor at last fall’s rates. The fact that inflation is falling even when more action is being taken should have us questioning whether a 4 percent move would have any traction. Also, for better or worse, if there was more disinflation after the 4 percent inflation target was announced, the Federal Reserve would likely see it as a major hit to its credibility.

Others think watching inflation is misguided, and we should instead be watching nominal GDP. That too may be in trouble. The NGDP chart that David Becksworth uses is showing a drop, last week showed a 0.1 percent decline in the Q1 2013 revision (instead of a rally), and with lower expected Q2 growth and disinflation real GDP is likely to fall further.

But my concern is that if the Federal Reserve is incapable of establishing even baseline “expectations” management of its institutional 2 percent inflation target at the zero lower bound, it’s not clear that it can do expectations management for brand new targets like nominal GDP while it is still there.

If zero lower bound monetary policy can’t manage a recovery through managing “expectations,” then ironically having something like a 4 percent inflation target in normal times is even more important. If the zero lower bound is this brutal to "unconventional" monetary policy, then it is even more important that we don't reach it. And we are less likely to reach it with more room. The question is how do we get to a situation where that is possible?

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