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In Which I Confess, Once Again, That I Do Not Understand the Argument for the Taper as Long as Inflation is Below Its Target...: Monday Focus

Graph Personal Consumption Expenditures Excluding Food and Energy Chain Type Price Index FRED St Louis FedOver at Equitable Growth:


Market-based measures of inflation expectations are not perfect, but... they have indicated that inflation is likely to be below target on average over the next five years. It would be shocking if that were not the case, given that the most recent Fed projections also indicate that inflation will be below target for the foreseeable future. We can debate whether the Fed has the right target.... Do you know what's not up for debate?... Setting a public target, consistently missing that target, projecting that the target will be consistently missed in future, and conducting policy so as to make sure the target is in fact missed: that is lousy monetary policy making. And I cannot understand why the Fed does not see this record as detrimental to the recovery and highly corrosive of the Fed's credibility....

I understand why so many people are uncomfortable with QE. It would be much more satisfying if the Fed could stimulate the economy by printing money to give to orphanages; sadly it is not allowed to do so. But... we should not let distaste with the means to drift into tolerance for a failure to achieve the Fed's self-adopted ends. So, QE critics, what should the Fed do?

As you know, I am of the view that the Federal Reserve ought to be following feedback rule by which it should add to its balance sheet when nominal GDP is below its target and reduce its balance sheet nominal GDP is or imminently threatens to rise above its target. Part of this is that it is not clear to me what the risks are of the Federal Reserve's having a larger balance sheet as long as inflation is and is expected to remain below its target. It has always seem to me that the more rapid and the more imminent the Federal Reserve can make expectations of economic normalization, the more will long-term interest rates approach their normal levels and the less tempted will be organizations, like commercial banks and insurance companies whose business model is that of holding duration, to reach for yield and so run excessive risks. Conversely, the more rapidly people expect the Federal Reserve's balance sheet to be unwound and reduced, the greater are the risks of getting stuck for a long time at the ZLB and losing not just one decade--we have already lost one decade of economic growth--but two.

I do not count the risks of the Federal Reserve would have to lose by selling long-term bonds some of the money it is made since 2007 as a risk at all. Does anybody else see that as a risk?

These are serious questions: How does prolonging the time the economy spends at and near the ZLB enhance financial stability? In what sense are the possible losses that the Federal Reserve would suffer on its bond portfolio from a rapid normalization of the interest rates a risk?

Does anybody have any answers?

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