Fed, Raise the Inflation Target

Friday's report of the personal consumption expenditure price index, which the Fed prefers, shows that year-to-year price index grew by 0.9% in February. This means that the inflation rate has been below the Fed's target of 2 percent inflation rate for 21 consecutive months.

While this low inflation rate has been allowing the Fed to pursue its quantitative easing program and low interest rate policy , the Fed policy makers also know that higher inflation rate around their target of 2 percent would make their job easier, simply lowering the real interest rate. But it seems like the Fed has been short of achieving its "target" for 21 months. A question we should ask from ourselves is that: is the Fed unable to hit its target? or is the Fed actually targeting lower than their so-called "target". In my Monday's post, I made a case for the second question getting an answer "yes!". If the Fed is indeed targeting inflation rate lower than its 2 percent "target", the points following are useless since the Fed policymakers want low inflation anyways.

Now if we are in the world where the Fed has actually been unable to hit its inflation "target" given that it wants to hit it so badly, my policy prescription for the Fed is to increase its inflation target from 2 percent to 3 percent or somewhere around that for the duration of the recovery. Note that, I am not suggesting to raise inflation target to 4 percent or other for the long-run as Laurence Ball and Olivier Blanchard suggested, but to raise it until the economy recovers.

The Fed could target this higher inflation rate by declaring in its meeting statements that the Fed will be comfortable with inflation rate considerably higher than 2 percent when deciding when to raise the fed funds rate. Let's look at the Fed's latest statement:

"To support continued progress toward maximum employment and price stability, the Committee today reaffirmed its view that a highly accommodative stance of monetary policy remains appropriate. In determining how long to maintain the current 0 to 1/4 percent target range for the federal funds rate, the Committee will assess progress--both realized and expected--toward its objectives of maximum employment and 2 percent inflation. This assessment will take into account a wide range of information, including measures of labor market conditions, indicators of inflation pressures and inflation expectations, and readings on financial developments. The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored."

The Fed, in my policy prescription, should change "run below the Committee's 2 percent longer-run goal" to "run below 3 percent" (or some rate around that). That change should have positive effect on inflation expectation. If the Fed believes the inflation expectation hasn't been responsive to its inflation rate target, that is great for the Fed since it could further state higher inflation target such as 4 percent to raise the expectation more while not actually raising the inflation higher.

But again, raising inflation target makes sense to me if the Fed does want to raise the inflation expectation. But considering its tapering QE even though their desired 2 percent inflation isn't seen to be reached for some time, I am puzzled by what inflation rate the Fed wants. Or are the Fed policymakers actually buying Stephen Williamson's paper?

Sorry Krugman, It Is Not Happening (or seems to be)

In his blog post on last Friday, Paul Krugman argues that the Fed should be targeting 4 percent inflation rate, which is, according to him, the inflation rate that is needed when the economy is at the zero lower bound, instead of current inflation target of 2 percent. He argues that by targeting inflation rate which is lower than a rate needed by the economy to get boost, the Fed does nothing to raise the inflation rate, which is currently below 2 percent, because even if the market believes in the Fed's target of 2 percent inflation rate at the beginning, its inflation expectation will decrease as time goes and actual inflation will be back at the low level. But, according to him, if the Fed explicitly targets 4 percent inflation rate, assuming 4 percent inflation is the right amount to boost the economy, this will give boost to the economy and hence drives the inflation up. However, the Fed is not even considering to target above 2 percent inflation rate as opposed to Krugman's inflation target of somewhere around 4 percent. We can see an evidence for the Fed being dovish.

In the Fed's recent statement, it dropped infamous 6.5 percent unemployment threshold for raising short-term interest rate. Known as the Evans rule, the Fed's former quantitative forward guidance statement was giving timeline for raising interest rate closely tied to the unemployment rate. As we know, once the unemployment rate unexpectedly (for the Fed) dropped to 6.6 percent in last month, it had to change its forward guidance program because if it had continued mentioning 6.5 percent threshold, and once the unemployment rate had reached the threshold, the Fed could have then made market expectation of increasing short-term interest rate when the economy needed the opposite. To avoid this unexpected mistake, they dropped the quantitative threshold for raising the interest rate.

The Fed undoubtedly has learned its lesson: Never underestimate the economy or should I say power of some number like 6.5? Having experienced the problem of changing the forward guidance appropriately, the Fed must have now issued their statement with great care of not choosing any random numerical threshold. But guess what? The Fed's statement still includes the inflation target of 2 percent. The Fed's latest statement reads:

The Committee continues to anticipate, based on its assessment of these factors, that it likely will be appropriate to maintain the current target range for the federal funds rate for a considerable time after the asset purchase program ends, especially if projected inflation continues to run below the Committee's 2 percent longer-run goal, and provided that longer-term inflation expectations remain well anchored.

Let's now imagine that somehow the inflation rate reaches around 1.9 percent in one of the coming months and assume the economy will not have gotten out of the recession slack (which is very likely), the Fed now faces the same problem it faced two months ago when the unemployment rate almost hit 6.5 percent threshold, but, in this case, only the inflation rate almost hits the target of 2 percent. Should then the Fed increase the federal funds rate according to its statement inferred if the inflation rate reaches 2 percent target? or should the Fed change its forward guidance again and drop the inflation rate target as it did unemployment rate threshold? Interestingly, the Fed will do neither of them because:

First, they learned its lesson of changing the guidance prematurely. Second, and more importantly, they KNOW that they will never face the inflation rate close to 2 percent during the recovery; hence, they won't have to do either of above.

In other words, from the Fed's current statement and its current mistake, we can almost be sure that it will never target the inflation rate above 2 percent as long as the economy is still recovering. Two percent inflation target is then an upper bound for the inflation rate the Fed targets.

Some people has argued even that the upper limit of 2 percent for the inflation target is indeed what the Fed has been pursuing for these years.

Therefore, it seems unlikely that Krugman will see whether 4 percent inflation target could get the economy back to work. Sorry Krugman, it is not happening (or seems to be).

Is There Wage Inflation? and Is That a Problem for the FED?

In the recent Wall Street Journal's daily report, Jon Hilsenrath writes about a possible wage inflation happening in the U.S. job market as discussed by Torsten Slok and Joseph Lavorgna, who are both analysts at Deutsche Bank. On one hand, Torsten Slok points out that there has been increase in hourly earnings recently. Indeed, hourly earnings of production and non-supervisory workers increased by 2.5% from a year ago.

This surge in hourly wage could make the FED worry about inflation pressure and change their timeline of raising the interest rate. However, as Mr. Lavorgna points out, this increase in hourly earning could be just a result of a decrease in average weekly hours worked as the case where,indeed, the average weekly hours  worked has dropped for last three months.

This drop in average hours worked could be a result of a bad winter we are seeing right now. But we have to be careful when reading Mr. Lavorgna's argument. We should take his argument strongly only if most workers are salaried workers since earnings for salaried workers are fairly less uncorrelated to the hours worked than earnings for hourly waged workers. That hasn't been the case recently; 59% of the total workers were paid on hourly basis in 2012. Therefore, there are factors we should be careful about on the both sides of the argument on the possible wage inflation. Once sunny days come again, we should look at the same data on hourly wage increase and change in hours worked to see whether wage is accelerating. 

Now, let's turn to the question: if wage inflation is indeed happening, does that mean there is a possible inflationary pressure coming?

The idea behind inflation driven by wage inflation is that when there is increase in aggregate demand for some reason and a following increase in demand for labor from firms, increase in wage accelerates. Facing the accelerating wage, the firms would raise their product prices.

However, this argument for wage inflation driven price inflation lacks some other factors that could make make the price inflation unnecessary. As discussed by Gregory D. Hess and Mark E. Schweitzer in their paper "Does Wage Inflation Cause Price Inflation?", the wage increase could be from increase in labor productivity. Also, the argument that the firms will raise their price to pay higher wage for workers isn't necessarily true if the firms are in competitive market and have no power over the prices. Moreover, in their paper they concluded the other way around that price inflation could drive wage inflation. Even though more study is need on the subject, the FED could be not worried about the existence of the wage inflation and the consequence of it if it exists for now.

Change in Expected Inflation and Its Effect on Investment and Spending

Greg Mankiw explained a possible tool for the FED to stimulate the economy under zero lower bound. He says that even the FED has already lowered the federal funds rate to close to zero, the monetary policy that creates a higher expected inflation in the economy could boost the economy. Mankiw explains that if the expected inflation is increased due to the FED's policy or other reasons, the real interest rate can be lowered. According to this argument, this lower real interest rate induces more investment because of negative correlation between real interest rate and investment. In his words:

"Other economists are skeptical about the relevance of liquidity traps and believe that a central bank continues to have tools to expand the economy, even after its interest rate target hits its lower bound of zero. One possibility is that the central bank could raise inflation expectations by committing itself to future monetary expansion. Even if nominal interest rates cannot fall any further, higher expected inflation can lower real interest rates by making them negative, which would stimulate investment spending."

How I see this argument is this: since a firm expects that the overall price in the economy to increase by more than  what it expected before, the firm would invest more in new capital than it was planning to do for two reasons: first, it would try to take advantage of low price more than it was planning before. In other words, since the firm expects the general price to go higher than it expected before, it will increase its today's investment to avoid paying this higher price in the future to buy capital. It is shifting its investment from the future to today. Second, when the firm's expectation of inflation increases, it would seek to borrow more money than it planned to do because the real interest it will pay in the future decreases. In other words, they just cannot resist this lower real interest rate in the future; therefore, they will borrow money today and invest in whatever plan they could think good.

The part I don't understand in Mankiw's argument is how the change in expected inflation could affect the real interest rate today.

In his General Theory, Keynes writes:

"The expectation of a fall in the value of money stimulates investment, and hence employment generally, because it raises the schedule of the marginal efficiency of capital, i.e., the investment demand-schedule; and the expectation of a rise in the value of money is depressing, because it lowers the schedule of the marginal efficiency of capital. (p.142)

Keynes says that any possible affect of the increase in expected inflation on the investment is through the higher schedule of the marginal efficiency of capital. What I am understanding as the schedule of the marginal efficiency of capital is the firms demand for investment.

Now on the effect of higher expected inflation on consumption spending, it seems to be reasonable to expect that people would spend more today if their expectation on the general price rises. Of course, whether it is true or not depends on in what time period we are talking about the inflation expectation. If people raises their expectation of inflation in the near future, they try to adjust their spending accordingly. Also, the effect on consumption differs for durable goods and non-durable goods since the absolute change in the prices of durable goods tend to be higher than that of non-durable goods. Because of this possible effect on the spending, there could be increase in overall prices today. In other words, a higher expected inflation could cause increase in prices today. However, this possible positive relation between the change in expected inflation and spending isn't clear. In their paper in 2012, Bachmann et al concludes following: 

"We find that the impact of inflation expectations on the reported readiness to spend on durable goods is statistically insignificant and small in absolute value when compared to other variables, such as household income or expected business conditions. Moreover, it appears that higher expected price changes have an adverse impact on the reported readiness to spend. A one percent increase in expected inflation reduces the probability that households have a positive attitude towards spending by about 0.1 percentage points. At the zero lower bound this small adverse effect remains, and is, if anything, slightly stronger."

We still lack empirical study on the effect of the change in expected inflation on the spending. In my curiosity, I looked over some data on the monthly change in the expected inflation, quarterly percent change in the investment and monthly percent change in consumption spending.  From this graph, we cannot tell whether the higher expected inflation induces more investment or higher consumption spending. Of course, we need to do empirical research to claim whether it is true or not. In conclusion, I don't see or understand the stimulating effect of the higher expected inflation on the economy as Mankiw and others see it. Therefore in my opinion,  the effect of raising inflation expectation by monetary policy, which is one of the two main tools that some people suggest in today's case of zero lower bound problem, isn't clear. The other tool, quantitative easing, seems to be more effective under zero lower bound.

Asset Boom vs Low Inflation

Since the Fed announced that it would start trimming it's bond buying program of $85 billion a month to $75 billion in the face of better economic outlook in December, the certain members of the FOMC have been open about their opinion on the Fed's recent QE program.

Being one of the strong critics of the program, Federal Reserve Bank of Dallas President Richard Fisher has been arguing against the whole bond buying program. In his opinion, the bond buying program does nothing much to the recovery, and the Fed should have cut back the amount of monthly bond purchase by $20 billion instead of $10 billion. Moreover, Fisher worries about increasing price of stocks and other assets. He isn't alone to warn about the bond buying programs push on asset price as stock prices are up 30% from a year ago. The worrisome result of the program is that "the boost to wealth and consumer confidence has accrued almost exclusively to the 52% of Americans who own stocks, based on a Gallup survey. It has not flowed through to jobs as the employment-to-population ratio has remained at 58.6% of the working-age population, within tenths of a percent of the recession low", according to RANDALL W. FORSYTH on Barron's. In other words, the bond buying program's main effect has been on the upward movement of the stock and asset prices but not much on the employment. The employment-to-population ratio has been lower than what it was at the "official" end of the recession, namely 59.4%, in June 2009, let alone before the recession ratio 62.7%. But we have to be careful here; to judge the QEs' effect on the economy, we should compare how the economy has been doing to how it would have done without the Fed's bond buying programs. Therefore, the judgement on the unemployment rate should be considered with a research on an "imaginary" economy without the QEs. However, the other point made in the above quote on the distribution of the Fed's high powered money and the beneficiaries of the FED's program, namely asset owners. The Fed's policy, therefore, could be a factor that is widening income inequality. Increasing income inequality should be tackled as soon as possible as it is growing as never before.

On the other hand, some members of FOMC have been big proponents of the Fed's bond buying program. Being one of them, Chicago Fed President Charles Evans has been taking strong stand on the continuation of the program to boost the recovery. He, among others, is worried by not-so-much inflation rate of 1.1% in the last year, which is well below the Fed's targeted level of 2%. To boost it to this targeted level, the Fed should pursue its near zero percent interest rate policy with its bond buying program, according to him. With low inflation, consumers and businesses have low incentive to borrow and spend their money. Therefore, the Fed is targeting high enough inflation to give confidence to consumers and businesses.

In other words, the Fed's policymakers have been divided between a policy against increasing asset prices and a policy against low inflation. Of course, it is not like "black vs white" argument. Fortunately, the monetary policymakers have been critical of each possible effect of the program.