I’ll explain what the Fed’s move on inflation hides
The analysis by Mario Seminerio, editor of the blog Phastidio.net , on the revision of the Fed's plans on inflation
The president of the US central bank, Jerome Powell, has announced that the revision of the Federal Reserve 's strategy will aim to allow inflation above the 2% threshold, to compensate for the low values of previous periods. A revolution? Not exactly. More than anything else, the acknowledgment of a bankruptcy, which certifies that the issuing institutions are not those omnipotent entities that we have all talked about in the last few decades.
Powell's key phrase:
Following periods where inflation has been below 2%, it is likely that appropriate monetary policy will aim to achieve inflation moderately above 2% for some time.
WHAT WAS NOT SAID
The news had long been in the air, so little surprise. However, what has not been disclosed is the length of the inflation observation period, to compensate for any deviations below the threshold. One year? Two? Five? Ten? Not knowing this allows the Fed to keep its hands free and avoid being predictable and predicted, which would reduce the effectiveness of monetary policy.
The price to pay, for this obscurity of the rule, is the likelihood that the markets will discount more uncertainty. Risk that Powell has taken care to reduce, stating that the Fed is ready to act if inflation expectations exceed levels consistent with the objective.
Another qualifying point of the Fed review is the asymmetry in the evaluation of the labor market with respect to inflation risk. After noting in recent years, not without surprise, that unemployment can fall well below the level at which the models associate the appearance of inflationary pressures, now the Fed promises that monetary policy will evaluate the employment "hole" against at its maximum, and no longer the "deviations" from it.
If it's not clear to you, don't worry: it isn't clear to central bankers either. Or rather, it is clear to them that the Phillips curve has flattened out dramatically, and as a result it is possible to have very low unemployment and non-existent inflation. After that, one might wonder what usefulness the new formula could be, if it is still necessary to estimate the “maximum” employment level, and on this estimate in the past he has been wrong several times. But transeat.
WHY INFLATION AT 2%
The North Star remains this blessed or cursed 2% inflation. But many have realized that central banks around the world have simply failed to achieve it, and that failure has lasted for many years. What does this mean, in a nutshell? This: what credibility can central banks have that fail to achieve their objective when they reformulate the objective itself?
But why are central banks stuck with this 2% inflation? For one reason: if, during a recovery, rates do not rise noticeably, as they did in another geological era, what will happen when the next recession arrives? Simple: that central banks will have no room to stimulate the economy by lowering rates. Or rather, they could lead to negatives, but the effectiveness and side effects on the economy remain unclear. Some might say that they are very clear, however: stock boom and increase in equity inequality. He would be right.
My points, then? First, that the Fed has acknowledged the reality, and little else. Then, that the credibility of central banks, in terms of pursuing an inflation target, is seriously damaged if not compromised. Some time ago there were those who went so far as to advise to bring the inflation target from 2 to 4%, to be more comfortable in reducing rates in recession. But here too, the same argument: if a central bank is not credible in reaching 2, can it be credible in reaching 4?
THE REACTION OF THE MARKETS
And the markets, how did they react? On the face of it, with an increase in yields and a steepening of the curve, that is, with a greater increase in yields on long maturities than on the closest ones. Which makes sense, as it is a reaction to rising inflationary expectations, ceteris paribus. But we will see in the coming days and weeks if that effect is going to be persistent.
QUESTIONS AND SCENARIOS
I have some unanswered questions left. For example, what if markets increase the inflationary risk premium, raising bond yields and causing restrictions on financial and credit conditions, and burdening debt service for many companies? Will the Fed decide to intervene and repress this phenomenon, perhaps announcing a Yield Curve Control (YCC) strategy, which nails yields on a maturity, typically 10-year, whatever happens? But in that case, wouldn't we risk monetary disorder, with increasingly negative real rates and investors who suddenly decide to get rid of all the bonds they hold?
It is not a science fiction scenario: if there is no inflation today, it does not mean that inflation is dead. There are obviously structurally disinflationary forces at work (such as an aging population and new technologies), as well as deflationary forces, for example the risk of the bursting of the mega-bubble of debt created in the world in recent years. But the inflation death announcements are vastly exaggerated, as Mark Twain would have said.
We then continue along a narrow path, with poor visibility and cliffs on the side of the road. For now, we can thank Powell for allowing empirical reality to drive strategic rethinking. Perhaps it is the minimum wage, for the most powerful central bank on the planet, the one that once shaped empirical reality and now has to adapt to it. From here to say that central banks are able to control inflation there is a lot, however.
(Extract from an article published on Phastidio.net )
This is a machine translation from Italian language of a post published on Start Magazine at the URL https://www.startmag.it/economia/fed-inflazione-strategia-spiegata/ on Sun, 30 Aug 2020 08:20:35 +0000.