"Catching up" with Jerome Powell
This weekend I attended the annual economic summit at SIEPR, Stanford’s Institute for Economic Policy Research. Lots of food for thought. Here I want to reflect on some of the issues that Fed Chairman Powell raised in his concluding speech. (now available on SIEPR’s Facebook page).
Powell exudes pragmatism. He conveyed the impression of a Fed well aware of what we do not know or understand about the economy. A Fed determined to learn more; but also determined to proceed cautiously with any changes—both in policy and in the policy framework—given that what it has done so far has worked quite well.
One of the things we don’t understand well is why inflation has not picked up more strongly, even as unemployment dropped to historically low levels. Globalization and technology have played a role: online retailing brought stronger competition and lower transaction costs; global commerce has allowed a stronger supply response from lower-cost countries.
Powell, however, stressed that the biggest reason why inflation has become less responsive to swings in unemployment is the Fed’s own credibility—bought at a high price by Paul Volcker in the 1980s. Powell noted the credibility works in both directions: during the Great Recession inflation did not fall as far as we could have feared.
This should be reason for celebration, not concern.
What worries Powell, however, is that interest rates have trended lower over the long term. If the new equilibrium level of interest rates is lower, then the Fed gets stuck closer to the zero bound, which means it will have less room to cut interest rates in a downturn. Deflation might again become a risk. This concern has triggered proposals for new monetary policy strategies, which the Fed will take under consideration.
A leading proposal is for the Fed to run “catch up” periods of above 2% inflation to make up for periods of below 2% inflation.
That strikes me as a very bad idea.
Say that for five years inflation runs at 1% instead of the targeted 2%. The Fed would commit to keeping monetary policy loose enough to boost inflation to 3% for the following five years; or perhaps to 4% for the following three years—both options would bring overall prices to the same level as if inflation had been running at a steady 2% all along.
But why would you expect that to work? As Powell noted, this works in theoretical models that assume households and businesses understand the strategy, believe it, and behave accordingly—something that is very unlikely to hold in the real world. In a scenario where the Fed has been unable to keep inflation at 2%, why would you believe it will be able to boost inflation to 3% or 4% for a set number of years and then bring it back down to 2%?
Powell made it clear that the bar to adopt such a strategy is very high—which I find both pragmatic and reassuring.
It is also not clear to me why such a catch-up would be desirable in the first place.
The 2% target was chosen with the following broad rationale: we want positive inflation to create some room for relative prices in the economy to adjust (on the assumption that nominal prices and wages cannot fall), which in turn helps allocate resources efficiently through the economy. At the same time, we want it low because higher inflation tends to be more volatile.
I see no evidence of distortions in resource allocations due to the fact that low inflation has prevented the needed adjustment in relative prices. If anything, it’s credit booms and the subsequent contractions that cause major distortions in resource allocation, as the BIS has shown.
You can argue that the catch-up strategy would represent a credible commitment to keep monetary policy loose for longer, reducing downside risks to growth and inflation. But it’s not clear why it would work any better than forward guidance or Quantitative Easing, which have already proved effective.
Another idea is to set a permanently higher inflation target of say 4% rather than 2%, proposed among others by Blanchard in 2010. The risk, however, is that changing the target might damage the Fed’s hard-earned credibility, to then discover that keeping inflation anchored at 4% is a lot harder than at 2%.
Powell made it clear that it would take a long and rigorous process of validation before the Fed considers adopting any of these new strategies. But he argued that we do need to study different options, because the ‘normal’ level of interest rates is now permanently lower for structural reasons, including aging populations—which boosts demand for safe assets—and lower productivity growth.
I am not convinced. The wide range of technological innovations already in the pipeline could easily boost productivity growth in the next few years. Demand for safe assets has been strongly skewed by central bank purchases, so we might be over-estimating the role of demographics. Finally, sovereign funds in oil-rich countries and China’s current account are now a much smaller source of demand for US Treasuries—as oil prices have dropped and China’s current account has shrunk considerably.
But even if you are as skeptical as I am, Powell’s pragmatic approach works well: let’s study possible alternative strategies, and in the meanwhile we will see whether these downward pressure on interest rates persist or not.
One final comment. Deflation fears play an important role in this debate. We have seen one example of dangerous deflation – Japan. We know that the underlying cause of Japan’s woes has been a nexus of zombie corporates, zombie banks and an overhang of debt. Monetary and fiscal policy mistakes made it worse, and inflation expectations have become a problem, but the root causes were in the real economy. If we want to prevent deflation, that is what we should worry about. And one downside of persistently cheap credit: it makes it easier for zombie companies to stay alive and for bad debts to rise.