"Passing the Baton": The Interview

That the Bernanke Fed responded to hitting the zero lower bound by lowering its inflation target always struck me as not sane. Yet that is what it did. It went from a 2.5%-per-year core PCE chain inflation target to an asymmetric 2%-or-less-per-year core PCE chain inflation target:

Personal Consumption Expenditures Chain type Price Index FRED St Louis Fed

Paul Krugman back in 1999 demonstrated that a flexible-price economy in which Say's Law holds reacts to hitting the zero lower bound on interest rates with an immediate and discontinuous drop in the price level in order to generate the inflation it needs for the zero nominal interest rate to generate the right neutral real interest rate so that full employment can be maintained. A central bank has one major job: to make Say's Law true in practice even though it is false in theory by pushing the real interest rate to the neutral rate.

Thus there are two not-wrong ways to deal with the zero lower bound problem:

  1. Keep your inflation target high enough that you do not hit the zero lower bound.
  2. If you do hit the zero lower bound, immediately do everything you can to push the inflation rate up until the zero nominal interest rate you have generates the neutral rate interest rate you need.

The Federal Reserve did not do either of the two not-wrong things in the early 2010s. The Federal Reserve's forthcoming "fundamental rethink" will not include an acknowledgement that the Bernanke Fed did a wrong thing in the early 2010s. And according to Gavyn Davies it has already taken the possibility of adopting a policy of doing the right thing—doing either of the right things—off the table. This is not good:

Gavyn Davies: Federal Reserve’s Fundamental Rethink About Inflation: "One idea for avoiding the Japanese deflationary trap is simply to raise the existing inflation target... Clarida has specifically ruled this out.... When prices fall below the long-run 2 per cent target during a recession, the Fed would credibly commit to compensating for this error during the subsequent recovery... the short run inflation rate may exceed 2 per cent while the catch-up to the long-term path occurs...

#noted #monetarypolicy #economicsgonewrong