This report assesses some of the external realities or economic fundamentals that will guide and temper the Fed’s ongoing review of its strategy, tools and communication.
The report is longer than usual and fairly heavily documented, particularly with links to other people’s research. This reflects that I am trying to set out the influences that — by my lights — will inevitably guide the Fed’s decision here, rather than just to suss out what Jerome or Richard or John are “really” claiming to think today. Some of what I present here is both abstract and meaningfully away from consensus. But I am fairly confident this report will have a decent shelf life and that working through it may help you interpret some of the upcoming Fed speech related to the review.
The main point raised by this report is that the primary result of the review will most likely be a hardening and further clarification of the Fed’s intention to really heavily on (dovish) interest rate guidance to provide stimulus in the wake of the next business cycle peak. This will not represent a major departure from what the Fed did after late 2008. But this time around the central bank is likely to act more deliberately, with more immediate clarity that the rates guidance will be conditioned on the achievement of economic results rather than calendar dates. There will also be less emphasis on QE, particularly internal to Fed deliberations. However, I do not expect the Fed to swear off use of the tool or even to avoid using it in the event. It is merely that QE will now be more clearly be secondary.
The inflation objective will not change. The Fed leadership has already pre-announced that. There will be some discussion of how the Fed might more reliably hit the unchanged 2% long-term objective for headline PCE inflation. But the current economic backdrop militates against the idea that the Fed will dial up its commitment to hitting the 2% objective, even over the medium term. The Fed may well hit 2% anyway, if the Phillips Curve reasserts itself or the Fed runs into some other form of good luck. But they cannot commit much more forcefully than they already have.
There are two key external issues related to the inflation side, the first of which is broadly familiar, and the second of which I am somewhat out of consensus in emphasizing. The first issue is that a flat (or even non-existent) Phillips Curve will make it hard for the Fed to pursue its inflation objective, even over the medium term, because doing so adamantly may involve intolerable destabilization of the labor market. People are familiar with this argument, but I perhaps put a higher emphasis on it.
The second issue is that the longstanding premise that a central bank with sufficient will and flexibility is certainly able to choose its inflation rate may be false. This will no doubt strike you as jarring, and I don’t fully support the assertion in this study. I should say that the claim is not central to my forecast that the Fed will have to soft pedal the inflation objective, perhaps using weasel words to obscure its decision not to be more forceful. But I lay down a marker here, for whatever its worth. And I hope you find that marker interesting. Let me know if you would like to bet I am wrong — and how we might set that bet.
In the meantime, ahead of the next business cycle peak, the Fed will continue to pursue what I have chosen to call Prospective Price Level Targeting or PPLT. The practical implication of PPLT is that the Fed’s preference is for above-2% inflation right now, as it tries to compensate ahead of time for the inflation undershoot that can be expected to develop during and immediately after the next recession. This preference is obviously a dovish influence, although it does not follow that the Fed will pursue higher inflation to the exclusion of all other considerations. Even now, they do not want to destabilize the labor market. Moreover, this is idea of PPLT is something the Fed would want to keep on the down low, even presuming I am right that it drives their current preference regarding inflation.
So for now, it will be PPLT quietly. And the Fed may soon telegraph that they will shift to favor some sort of watered down temporary price level target or average inflation target after the next business cycle peak. But beyond the current framework, we ought not expect much new on the inflation side. The focus of the review will most likely be on how best to deliver interest rate guidance during the next recession and early recovery.
And it may help to have a program to guide you on how the Fed leadership will choose to express these ideas, which I hope to have produced here.