When the Chairman discusses the FOMC's medium-term inflation objective, we suspect that many in the market interpret him as saying that the inflation goal is also a near-term objective. This interpretation undermines the FOMC's ability to ease under current circumstances.- If the "2% or slightly below" inflation objective were also a short-term goal, the FOMC would respond to even short-term deviations of core inflation from its target.
- It appears that the fact that year-to-date core inflation is running slightly above 2% is a constraint on whether, how, and how aggressively the FOMC is prepared to ease.
- Our interpretation is that the FOMC is not actually so set on hitting the 2% inflation objective over the near term, but market perceptions do matter, especially when those perceptions are a risk to the stability of longer-term inflation expectations.
A key issue is providing clarity on how tolerant the FOMC is, or should be, about short-run departures of core inflation from 2%. We propose a new policy regime, called monitoring-range inflation targeting (MRIT, pronounced "merit") that provides such clarity.- Under MRIT, the FOMC announces an explicit medium-term headline inflation target-e.g., 2%-together with a short-term monitoring range for expected core inflation-e.g., 1.5% to 2.5% on a 12-month change basis.
- Under MRIT, if the labor market did not improve significantly, the FOMC would keep the funds rate "exceptionally low" as long as near-term core inflation was projected to stay within the monitoring range, provided, of course, longer-term inflation expectations remained consistent with the medium-term inflation target.
- We don't know whether the FOMC is or will be considering MRIT. We strongly believe that it should! Indeed, we believe it so strongly that we anticipate something akin to MRIT being announced, perhaps early next year.
With core PCE inflation not expected to move above 2.5% for a very long time, MRIT would signal that the FOMC expects to stay exceptionally accommodative well beyond 2013. - An advantage of MRIT over other easing options is that it doesn't involve an expansion of the balance sheet-as required by QE3-or a temporary increase in the effective inflation target-as would be the case under price level targeting.
- Like pure inflation targeting, MRIT would reinforce the medium-term commitment to price stability, but it would preserve the FOMC's flexibility in the short run.
- Like price level targeting, MRIT would signal a greater tolerance for higher inflation in the near term, but with lower risks to the stability of long-term inflation expectations.
An Inflation Targeting Regime with a Short-Run Monitoring RangeWe propose that the FOMC announce an explicit medium-term target for headline inflation and a shorter-term monitoring range for expected core inflation.[1] We refer to this as a "Monitoring-Range Inflation Targeting" regime," or MRIT.[2] For instance, the FOMC could announce a 2% medium-term target for headline inflation and a 1.5%-to-2.5% monitoring range for expected core inflation over the short term.
We strongly believe that the medium-term objective should be a point rather than a range, and that it should be expressed in terms of headline inflation. The emphasis on headline inflation would indicate that the Committee is focused on all prices, i.e., that it does realize that the public buys all goods and services, including gas and groceries! Setting the medium-term target as a point would help bring clarity to the Committee's ultimate goal and, importantly, distinguish it from the monitoring range.
The monitoring range would bracket the medium-term point objective. Setting the monitoring range for expected core inflation over the short term, rather than headline inflation, would reflect the Committee's long-standing view that core inflation is a better predictor of trends in headline inflation than is today's headline inflation. Headline inflation is just too volatile over the short run to be a reliable indicator of its trend.
Our proposal reflects our view that current circumstances should, and may, lead the FOMC to rethink the weight it places on achieving a strict inflation objective in the short run, relative to promoting full employment. In particular, given how far the FOMC is from its full-employment objective these days, the Committee should be able to put in place policies that are likely to lead to some short-term overshooting of its medium-term inflation objective.[3] But our proposal goes beyond addressing the current weakness in economic conditions. We view MRIT as a permanent new operating regime for the FOMC, one that would reinforce its commitment to price stability without jeopardizing its ability to address the other side of its dual mandate.
Why Do We Consider MRIT to be "Above the Line?" [4]In a recent commentary we discussed various options that we consider to be "above the line," i.e., options that would be in consideration under current circumstances. MRIT was not included in that commentary (because we hadn't thought of it at that time) but we consider it to be essentially a combination of two options that we included in that list: announcing an explicit inflation target and price-level targeting. Better still, we consider MRIT to have some of the key benefits of each of these two options but, potentially, without their drawbacks.
Similar to pure inflation targeting, MRIT has the advantage that it helps reinforce the stability of longer-term inflation expectations. Nonetheless, unlike pure inflation targeting, we believe that MRIT would not limit the FOMC's ability to provide further support to the faltering recovery (the other part of the dual mandate), even if current readings on core inflation are at or slightly above the mandate-consistent medium-term inflation target.
MRIT is similar to price level targeting in that it allows the Committee to temporarily tolerate a rise in inflation beyond the medium-term target. But under price level targeting, the extra tolerance for above-target inflation could lead longer-term inflation expectations to become unmoored, given that the public would not know how much of an overshoot would be tolerated by the Committee in the future.[5] In contrast, the Committee's tolerance of above-target inflation under MRIT is well defined and pre-announced (in the form of the short-term monitoring range).
Another advantage of MRIT over other easing options is that it doesn't involve an expansion of the Fed's balance sheet-as required by QE3-or a temporary increase in the inflation target, which has been advocated by some, but which, in our opinion, could lead to a significant un-anchoring of longer-term inflation expectations. Indeed, we don't even consider a temporary increase in the inflation target to be an above-the-line option.
The Benefits of MRIT TodayTo illustrate why the notion of a short-run monitoring range matters, consider the fact that year-to-date core inflation is running at slightly above 2% appears to be a constraint on whether, how, and how aggressively the FOMC should ease in response to the faltering recovery. The Chairman has pretty much said as much.[6] If, instead, the Committee had a short-term monitoring range along the lines discussed above, 2% core inflation would be no impediment for further easing, provided longer-term inflation expectations are still consistent with the Committee's medium-term inflation objective, as they are today.
MRIT would be especially helpful today when the FOMC is at the zero bound, GDP growth and unemployment rate projections call for more easing, and some, including many on the Committee, either expect or worry that inflation will move to 2% or modestly above. MRIT would signal that the Committee today is prepared to tolerate somewhat higher inflation in the short-run, compared to its 2% medium-term objective.
Under MRIT, if the labor market does not improve significantly, the FOMC would keep the funds rate "exceptionally low" as long as near-term core inflation is projected to stay within the monitoring range, provided, of course, longer-term inflation expectations remain consistent with the medium-term target. For instance, with core PCE inflation currently running at 1.6% (based on the 12-month change) and not expected to move above 2.5% for a very long time, MRIT would signal that the Committee won't start removing policy accommodation until well beyond 2013.
The Benefits of MRIT as a New Policy Regime We propose MRIT not as a temporary, emergency measure, but as a new, permanent regime. This would show a high degree of confidence that the Committee now believes that MRIT is "best-practice" monetary policy.[7]
A key benefit of MRIT is that it more fully addresses the Committee's dual mandate than would a pure inflation targeting regime. For instance, the medium-term inflation target component of MRIT fully incorporates the Committee's price stability objective, whereas the notion of a short-term monitoring range, which allows inflation to deviate from the medium-term objective over the short-run, would give the Committee the flexibility it needs to address the full-employment portion of its congressionally-mandated objective.
What about Long-Term Inflation Expectations?Could the FOMC really signal greater tolerance for moderately above-target inflation over the short run without upsetting long-term inflation expectations? We believe that confidence that the Committee can keep long-term inflation expectations anchored is the absolute precondition for proceeding with MRIT. Maintaining stable long-term inflation expectations is especially important, and perhaps challenging, if core inflation moves toward the upper end of the monitoring range over the next year or two.
How could the FOMC meet this challenge? The answer, of course, is effective communication. The Committee would have to be extremely clear about its intent and the short- and medium-term implications of the new policy regime for the conduct of monetary policy. An essential part of this communication must be to emphasize and hammer home that the FOMC is as committed as ever to achieving price stability (its medium-term inflation objective). The practical question here is whether Chairman Bernanke could get the job done. We think he can!
Blowing in the Wind?We have set out a proposal here that we think makes sense, that would be very effective today, and that dominates, perhaps by a wide margin, any other option the FOMC has available, especially QE3. We have not heard anyone, inside or outside the Committee, even mention this option.[8] So are we blowing in the wind, or is MRIT possibly an above-the-line option that might be discussed (though not implemented) as early as this month? We don't really know.
We admit that a motivation for offering this proposal is to increase the odds that the Committee will carefully look at it, sooner rather than later. We are being more speculative than normal here, but we can imagine something akin to MRIT being announced as early as January. But then again, maybe we're just too enamored with our own proposal!
The Bottom LineWe proposed a new regime for the FOMC, which we called monitoring-range inflation targeting (MRIT). Under MRIT, the FOMC would announce an explicit medium-term target for headline inflation and a short-term monitoring range for expected core inflation. A key benefit of MRIT is that it would reinforce the FOMC's commitment to price stability over the medium term while also giving the Committee some room to provide additional stimulus over the short run. We believe that MRIT dominates other easing options that are currently under consideration. In addition, MRIT could easily become a permanent new regime for the Committee and not just another emergency action taken to address the aftermath of the Great Recession. A main challenge with adopting MRIT is the risk that it might unsettle longer-term inflation expectations. This is a communication challenge that, we believe, could be handled by Chairman Bernanke. At any rate, other potentially effective easing actions currently on the table would present even greater communication challenges.
[1] We are not saying that the FOMC should ask Congress to change the Federal Reserve Act to set price stability as its single objective. As the Chairman has commented in the past, the Committee could put it in terms of a mandate-consistent inflation rate.
[2] The Bank of Canada's (BoC) inflation targeting regime comes the closest to our proposal. The BoC sets its inflation objective (called the "inflation-control target") as a range of 1% to 3% for headline inflation but indicates that it is aiming for 2% in the medium term. As a result, we view the BoC regime more as having a point target than a range target. The BoC also sets a shorter-term guideline for core inflation, called the "operational guide." This range, however, has no official status, and it was not mentioned in the "Joint Statement of the Government of Canada and the Bank of Canada on the Renewal of the Inflation-Control Target," November 23, 2006.
[3] Our proposal has some of the spirit of the risk management approach practiced under Greenspan. For instance, that approach held that, when there is a risk of deflation but no deflation in the forecast, the FOMC should put in place a policy so stimulative that it might overshoot its medium-term inflation objective if its forecast turns out to be correct.
[4] Please see our Policy Focus commentary, "Above the Line and Below the Line: A Peek into the FOMC's Easing Toolkit," August 25, 2011.
[5] In a price level targeting regime, the Committee operates as if it had a time-varying effective inflation target. In particular, such a regime can be thought of as one where the Committee targets an average inflation rate over a given horizon. For instance, if the averaging period were four years, and inflation were averaging a full percentage point below its target over the preceding two years, the Committee would then have to aim for approximately a full percentage point overshoot, on average, over the subsequent two years. If this sounds complicated, you're not alone. Explaining a price level targeting regime to the public would itself be a challenge, much less implementing it!
[6] Please see Chairman Bernanke's testimony on the semiannual Monetary Policy Report to the Congress on July 13 and July 14, 2011. Please also see his press conference on June 22, 2011.
[7] From a modeling perspective, MRIT would involve a non-linear policy function, whereby the FOMC doesn't respond to fluctuations in core inflation that still leave it within the monitoring range but reacts strongly when core inflation falls outside the range. Of course, the FOMC would respond vigorously to deviations of longer-term inflation expectations from the medium-term inflation target, as well as to conditions in the labor market.
[8] President Evans, to be sure, got close to it in a recent speech, though his thinking seems closer to price level targeting than to MRIT. Please see Evans, Charles, 2011. "The Fed's Dual Mandate Responsibilities and Challenges Facing U.S. Monetary Policy." Remarks delivered at the European Economics and Financial Centre in London, United Kingdom on September 7, 2011.
This is from a commentary that was published on September 7, 2011.
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