Sunday, February 3, 2008

Aim Slightly Higher

The unusually aggressive reductions in the fed funds rate target in the last two weeks have been criticized for increasing the potential for future inflation. One defense of the Fed is that the risks it faces are asymmetric. In particular, the Fed wants to make sure to avoid falling into deflation and a "liquidity trap" where monetary policy becomes ineffective - when the price level is falling, even if nominal interest rates go to zero, real interest rates can still be high. This is the point made in the FT's Economists' Forum by Johns Hopkins' Christopher Carroll:
[T]he Fed's gamble seems well judged, not because the concerns of the inflation hawks are unwarranted but because they are balanced by a more dangerous possibility on the opposite side. Put it this way: if I'm hiking a narrow cliff-hugging mountain trail, I don't want to stroll right down the middle of the path. Instead I will edge to the to the side of the trail away from the precipice, even if this means an occasional scraped ankle or a bit of extra scrambling. This is the "precautionary principle" in mountain-climbing.

The cliff, for monetary policy, is the possibility of deflation, whose dangers were calamitously illustrated by the Japanese government during the 1990s. And the precautionary principle would say that it is worth risking a spell of extra inflation to avoid even a small risk of a deadly dose of deflation.

The uptick in long-term interest rates (noted previously) might suggest that the Fed's actions are denting its inflation-fighting credibility and that inflation expectations are rising. One way to enhance credibility and keep inflation expectations anchored would be for the Fed to adopt inflation targeting (i.e. announcing a goal for inflation and committing to adjusting monetary policy to meet it). As an academic, in addition to being a student of the depression, Ben Bernanke was an advocate of inflation targeting.

Most of the countries that have adopted inflation targeting (e.g. Britain) have set targets of 2% (or ranges centered on 2%). If the Fed is indeed strongly deflation-averse (as it should be), perhaps 2% would be cutting it too close. Setting a slightly higher target - say 3% - would give the benefits of inflation targeting without requiring it to walk so close to the edge of the cliff. For example, if we start from an equilibrium at an assumed "neutral" level of the real fed funds rate of 2.5% and an inflation target of 3%, the fed funds rate would be 5.5%, giving the Fed 550 basis points to work with in a downturn (as opposed to 450 bps with a 2% target).

The downside of that, of course, is higher inflation. But many of the problems with inflation come more from uncertainty and volatility rather than the rate itself. Its not clear that an economy with consistent, anticipated inflation of 3% is much worse than one with consistent, anticipated 2% inflation. Moreover, if nominal wages are sticky downwards, a little bit of inflation makes it easier to adjust real wages (as Akerlof, Dickens and Perry explained).

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