By James McCann, Senior Economist and Luke Bartholomew, Economist
- The Fed is conducting a review of its monetary policy strategy as it seeks to repair the damage done to its inflation credibility over recent years, and bolster its policy firepower in a world of lower equilibrium interest rates.
- While it is positive that the Fed is evaluating its policy framework, it should also be mindful that the current framework is not to blame for its own policy mistakes since the financial crisis. The Fed repeatedly underestimated spare capacity, overestimated the level of equilibrium interest rates, and, partly as a result of both of these, generated inflation forecasts that were too high. This meant that the central bank provided insufficient policy support after the crisis and – on several occasions – sought to prematurely withdraw this accommodation.
- The review also decided not to consider more radical proposals. These included raising the 2% rate of inflation currently considered consistent with the Fed’s price stability, or shifting to a nominal GDP target. This opens the central bank up to the criticism from the off that it is being too conservative. Instead the focus will be on make-up strategies. Under this approach the Fed would not allow past deviations from its 2% inflation target to be treated as bygones. Rather, it commits to partly, or fully, reversing these shortfalls or overshoots from the implied price level.
- If credible, this approach should boost long-term inflation expectations and provide an automatic stabiliser for the economy. For example, amidst a period of low current inflation, the new framework would require stronger offsetting actions. This would push inflation expectations higher in the medium-term and anchor long-term expectations at 2%. This would provide more real policy and labour market adjustment than in the current framework, particularly when rates hit the effective lower bound.
- There are, however, downsides. Given past experience, credibility might be hard to win for the Fed, especially when faced with difficult policy choices, implying that longer-term inflation expectations may only increase following a sustained period of success. At the same time, the switch to a make-up framework will provide a communication challenge as the bank moves away from its traditional inflation target. Finally, the new framework could expose the Fed to more political pressures.
- This paper outlines a range of different make-up strategies that the Fed could adopt, and assesses their relative strengths and weaknesses. We also model how the path of policy may have evolved under a credible make-up policy regime, and consider the theoretical impact on interest rate markets. Overall, our reading of current signals, along with an assessment of how we think the Fed is weighing up the various trade-offs associated with each approach, means we think an average inflation target is the most likely outcome. However, there is still time for the debate within what looks like a highly divided Fed to move in another direction.
The views and conclusions expressed in this communication are for general interest only and should not be taken as investment advice or as an invitation to purchase or sell any specific security.
Any data contained herein which is attributed to a third party ("Third Party Data") is the property of (A) third party supplier(S) (the "Owner") and is licensed for use by Standard Life Aberdeen**. Third Party Data may not be copied or distributed. Third Party Data is provided "as is" and is not warranted to be accurate, complete or timely.
To the extent permitted by applicable law, none of the Owner, Standard Life Aberdeen** or any other third party (including any third party involved in providing and/or compiling Third Party Data) shall have any liability for Third Party Data or for any use made of Third Party Data. Past performance is no guarantee of future results. Neither the Owner nor any other third party sponsors, endorses or promotes the fund or product to which Third Party Data relates.
**Standard Life Aberdeen means the relevant member of Standard Life Aberdeen group, being Standard Life Aberdeen plc together with its subsidiaries, subsidiary undertakings and associated companies (whether direct or indirect) from time to time.