DRAFT: Did Macroeconomic Policy Play a Different Role in the (Post-2009) Recovery?: Monetary Policy: Choosing the Inflation Target
J. Bradford DeLong
October 15, 2016
At least since the start of the 1970s, the principal focus on monetary policy here in the United States has been inflation control. That focus is dominated by the experience of the 1970s; by the high cost in terms of unemployment, lost production, and slack in the early 1980s to eliminate the inflation of the 1970s; and by the subsequent belief on the part of nearly everyone associated with the Federal Reserve system that the anchoring of inflation at a relatively low level is an achievement that is very valuable, was very expensive to buy, and must not be risked.
The post-1984 “Great Moderation” era was thus extremely gratifying to a Federal Reserve that had been profoundly shaken by economic outcomes between 1970 and 1984. The low level and low volatility of inflation, combined with the “divine coincidence” of Blanchard and Gali (2007) that this seemed to bring with it low real-side cyclical volatility as well, convinced many that some sort of sweet spot had been attained.
Policymakers admitted that some of it had simply been good luck in terms of the relative absence of large shocks (Stock and Watson (2003)). Policymakers admitted that some of it had been good fortune in terms of the extra freedom opened by the post-1995 productivity speedup (Blinder and Yellen (2001)). But there remained a considerable piece that was regarded as a valuable treasure held by the Federal Reserve. Therefore the first imperative of monetary policy as made by the modern Federal Reserve as it has developed since 1984 or so is: do not risk the anchoring of inflation and inflation expectations at their low level.
But at what low level? What should the inflation target be? Or, perhaps, instead:
- What is the set of inflation rates with which the Federal Reserve is comfortable?
- What are the triggers that will induce the Federal Reserve to focus and take action, rather than worry, drift, and nudge?
Assessing whether and to what extent monetary policy since 2008 has been different and behaved differently requires we have a view of what our inflation target was, both explicitly in what was said and implicitly in what outcomes would either move the Federal Reserve out of its comfort zone or trigger action. Was the Federal Reserve targeting inflation during the Great Moderation?
The answer is: yes and no.
At any moment, there was a band of inflation rates and a set of trajectories with which the Federal Reserve was comfortable. Deviations would induce worry, pressure, and action—eventually. There were triggers that would induce an immediate change of course. And policy was steadily drifting year-after-year toward a more formal inflation target as a way of attempting to manage expectations via commitment. By 2004 Larry Meyer (2004) was willing to say: “If you do not know that the Federal Reserve is targeting 2%/year inflation, you have not been paying attention…”
To help understand this process, I propose dividing the post-1984 “Great Moderation and Beyond” period into four pieces insofar as our understanding of what the Federal Reserve was aiming at in terms of inflation targets, or inflation comfort zones:
Before 1990: Comfort with 4%: The Federal Reserve appears comfortable with inflation in the range of 4% per year or so. The memory of the 1982 unemployment peak is still recent enough that there is little appetite for any policy steps to transform what appears gratifyingly low inflation by the standards of the 1970s into anything that could be called “effective price stability”. But inflation rising and forecast to rise higher than 4% definitely carried the Federal Reserve out of its comfort zone, and triggered action—no matter what commitments George H.W. Bush’s administration had thought Greenspan had made to them in 1997 back when Bush was Vice President (DeLong (2008)).
1990-1995: Opportunistic Disinflation: But as the memory of the unemployment spike of 1982 became more distant, a lower inflation rate than 4% came back on the Federal Reserve’s menu as a desirable goal. But it was seen not as a policy to be pursued actively. It was, instead, something that was to be attained passively. The Federal Reserve, so the current of thought went, should not seek to reduce inflation, but should take advantage of opportunities in which inflation was by accident already reduced.
As Philadelphia Federal Reserve Bank President Edward Boehne said in 1989:
Sooner or later, we will have a recession… If… we took advantage… and we got inflation down from 4.5 to 3% percent…. If we could bring inflation down from cycle to cycle just as we let it build up from cycle to cycle, that would be considerable progress…
And, of course, the recession he saw as coming “sooner or later” was already on the way.
1990 to 1995 sees the Federal Reserve “opportunistically” acquiesce in the reduction of inflation from 5% down to 2%. It was not a primary focus of Federal Reserve policy thinking. Policy thinking in those years was dominated by the S&L crisis, the recession, the “jobless recovery”, the interaction between monetary and fiscal policy, the greater potential attractiveness of a “Wicksellian” as opposed to a Keynesian or a monetarist framework, and the peculiar gearing between short- and long-term interest rates apparently induced by the endogenous duration of mortgage-backed securities—plus the possible coming of a “new economy” and the declining weight of GDP. The reduction in inflation was for the most part just something that happened. And the Federal Reserve was not unhappy about it.
1995-2008: Stick at 2%: But thereafter “opportunistic disinflation” is not pursued further. There is no appetite for policies to reduce 2% to 0%. Rather, after 1995 inflation at a rate of 2% per year is redefined as “effective price stability”, and held to fulfill the Federal Reserve’s legislative mandate: that even if there were no impact on employment or growth, 2% would still be what the Federal Reserve would choose and would want to see.
A number of arguments were provided for this. Greenspan (1997) saw “a very high probability that the upward bias [in price measurement] ranges between 0.5… and 1.5%-points per year…” and said that true deflation should definitely be avoided. Long-term budget balance seemed a desirable goal that the Federal Reserve should assist with to the extent of not handing out large windfall real gains to holders of long-term government debt. Worries about curvature in the Phillips Curve as inflation approached zero along the lines of Akerlof, Dickens, and Perry (1996) concerned many.
But the explicit cost-benefit analysis involved in the choice of target did not seem to be a major focus of discussion within the Federal Reserve system. Greenspan seemed to have chosen 2%, and the response seemed to be to fall in line and seek reason why this was a wise choice.
From today’s perspective the stakes in those decisions to acquiesce in opportunistic disinflation to 2% and then to stick at 2% rather than heading for zero appear to have been very large indeed. And they seem worthy of more thought along the lines of DeLong and Summers (1992) Krugman (1998), DeLong (1999), Fuhrer and Sniderman (2000), Blanchard et al. (2010), and Ball (2014).
Post-2008: The Undershoot: Since 2008, of course, there is the persistent undershoot of the 2% inflation target by an average of about 0.5%-points. It is not that at the Federal Reserve has aimed at an undershoot. As of the end of 2009, the FOMC expected that inflation would increase and that the economy would strengthen sufficiently that it would normalize the Federal Funds rate to hailing distance of 5% within a timer period in hailing distance of three years. It is not as though the Federal Reserve was in some sort of a unique overoptimism bubble. Until recently, at least, markets have expected a much stronger outcome as well—although not as much stronger as history has delivered as the FOMC. Today markets are very pessimistic. And the FOMC expects to be able to normalize the Fed Funds rate to 3%… sometime…
The longer this continues, however, the less convincing are arguments that it is due to forecast error, accident, and bad luck; and the more convincing are arguments that it is due to institutional biases and either policy choices or policy limitations that appear to make 2% more of a ceiling than of a target.