Fed to raise its inflation game?

The Fed's challenges

The Federal Reserve could announce significant changes to its monetary policy approach early next year.

Sources: BlackRock Investment Institute, with data from Bloomberg, May 2019. Notes: The chart shows the market pricing of inflation based on five-year forward inflation in five years' time. The Fed target is adjusted 25 basis points higher to account for the difference in market pricing of the CPI index in inflation swaps relative to the PCE inflation index, the Fed's target. The ECB targets inflation just below a 2% reference point.

An in-depth review is in full swing. The policy review aims to address the challenges faced by central banks in the aftermath of the global financial crisis. These challenges are rooted in falling neutral interest rates – rates that would neither stimulate nor hold back economic growth – and declining inflation expectations. Both of these could limit the ability of monetary policy to counter future downturns.

These two factors reduce the distance between the actual interest rate and the effective lower bound (ELB) – the minimum level of interest rates that the central bank can feasibly set. The negative policy rates in Japan and the eurozone, for example, show that this level can be below zero. Interest rates below zero could harm the profit model of the banking sector and even lead to depositors – who may have to pay the bank to hold their money – withdrawing their money from the system.

We assess the implications of any shift from the flexible inflation forecast targeting that the Fed and other developed market central banks currently follow towards strategies that explicitly require central banks to make up for past misses of their inflation target –“make-up” strategies. These options are being discussed by the Fed, and other central banks – the Band of Canada and Sweden’s Riksbank – have pondered similar changes in the past. The European Central Bank (ECB) may also re-assess its strategy after a leadership transition later this year.

The debate in central bank circles – with the Fed leading the way – reflects two factors that could potentially limit the effectiveness of monetary policy in any future downturn. First, a decline in the neutral rate of interest implies that average policy rates are gravitating lower. Second, after an extended period where inflation has been below central bank targets, inflation expectations are becoming untethered and shifting below inflation targets on a sustained basis. See the Lying low chart above.

Projections by the Fed (Roberts and Kiley 2017) suggest that the ELB could become a constraint for US monetary policy for around one third of the time – a risk that had been very small prior to the Great Recession. Once the ELB is reached, the Fed cannot reduce interest rates any further in a recession. This means unconventional policies –such as quantitative easing (QE) – would again become the second-best instruments of choice. Then, the inability to cut rates further could lower inflation expectations again, potentially shrinking monetary manoeuvring room even more. There is an obvious desire to avoid the deflation spiral and liquidity trap problems seen in the Great Depression – or in Japan.

Assessing the options

A shift towards a “make-up” strategy could have considerable repercussions for financial markets, provided that the new strategy is credible and well understood.

Sources: BlackRock Investment Institute and Bernanke et al (2019), May 2019. Notes: The top chart shows our illustrative demonstration of the hypothetical behaviour of price levels under the current inflation targeting policy and price level targeting (PLT) as time passes. The bottom chart shows the simulation results from Ben Bernanke's paper showing the expected average levels of various macroeconomic variables of under different monetary policy rules over an entire business cycle. The estimates are generated by simulating the Federal Reserve’s FRB/US large-scale macroeconomic model. Forward-looking estimates may not come to pass.

A shift towards a “make-up” strategy could have considerable repercussions for financial markets, provided that the new strategy is credible and well understood. The Fed has never deliberately forecasted a material inflation overshoot. Market participants would have to change their understanding of how the Fed would use monetary policy in any given situation. Much would depend on whether short-term inflation expectations can move decisively above target when recent inflation has been below target (and vice versa). Additional ramifications could result from markets changing their expectations of the range of long-term macroeconomic outcomes and the near-term policy path of the Fed.

Different monetary policy ideas have been proposed on the central bank conference circuit. These can mainly be divided between price level targeting (PLT), average inflation targeting (AIT) and temporary price level targeting (TPLT). PLT commits to make up any deviation from the inflation target by leaning in the opposite direction in the future. AIT commits to achieving an average inflation level over a set period of time. As the period over which inflation is averaged gets longer, the monetary policy strategy converges from inflation targeting to PLT. Both PLT and AIT include past inflation outcomes in monetary policy decisions of the present policy stance.

Under temporary price level targeting, the central bank temporarily switch towards PLT when interest rates reach their floor (when the ELB is reached), and reverts back to its standard flexible inflation targeting once it has made up for the temporary inflation shortfall. The strategy – put forward by former Fed Chair Ben Bernanke in a 2017 blog – essentially introduces a temporary change to the central bank’s monetary policy norms. It aims to balance the pros and cons of PLT versus traditional inflation targeting. According to economic models, TPLT can provide sufficient stimulus at the ELB while avoiding excessively loose monetary policy and an overheating economy later. See the Policy paths charts above.

A fudged framework

A few common themes emerge when comparing policy interest rates under the current system with the alternatives under consideration.

Sources: BlackRock Investment Institute, May 2019. Notes: This table shows our assessment of how financial markets may respond to the implementation of a new Fed policy framework if the framework is perceived to be credible. PLT refers to price level targeting. AIT refers to average inflation targeting. Forward-looking estimates may not come to pass.

A few common themes emerge when comparing policy interest rates under the current system with the alternatives under consideration. Thousands of model outcomes can be summarized in four main features of make-up strategies: First, the economy returns more quickly to a steady state (where inflation is at target and the output gap is closed) after a downturn. Second, interest rates would likely stay lower for longer. If the Fed had adopted any one of a number of make-up strategies after the global financial crisis, it would probably not have started to raise rates from post-crisis lows – even by now. Third, macroeconomic volatility could decrease. See the table above. Lastly, asset bubbles could become more common – unless macro prudential rules are tightened when make-up strategies are in place.

A number of conclusions on the market impact of make-up strategies emerge. First, the current US expansion could have years more to run. This is because the willingness to consider make-up strategies suggests lower-for longer interest rates and therefore a bias towards easier rather than tighter monetary policy – and a lower chance that a policy mistake could cut short the expansion. But other potential risks to the recovery would need be monitored closely because financial vulnerabilities would likely build up faster.

Second, longer term inflation expectations could shift upwards. History suggests that the expectations of professional forecasters gradually converge to the new target over a couple of years. Private sector expectations, such as household inflation expectations, gradually catch up with professional forecasts.

If the Fed decides that a make-up strategy should be implemented, we believe that the future chance of extreme macro outcomes – especially a recession deepening into a full-blown depression because of a lack of monetary policy firepower – may be reduced. This is because the ELB may not become a limiting factor as often. The risk of full-blown deflation would also decline, in our view. The lower chance of these negative events – combined with lower-for-longer interest rates and higher long-term inflation expectations – would likely support risk assets.

Volatility – currently low by historical standards – could also change. Medium-term macroeconomic volatility would likely decline under credible make-up strategies. Volatility could also rise in the short term while the market digests any new Fed inflation strategy. Effective Fed communication would be needed to manage this transition.

But in reality, any actual implementation of AIT (or other make-up strategies) is likely to be diluted. As the Fed’s Richard Clarida said in May this year, “our review is more likely to produce evolution, not a revolution, in the way we conduct monetary policy.” The more central bankers say there won’t be a big change, the lesser the likely impact.

Policymakers may only introduce a new strategy during the next downturn. They may also be wary of financial overheating and the resulting risks to financial stability. Importantly, AIT depends on the successful manipulation of inflation expectations, something central bankers have been unable to effectively do during this economic recovery. Some of the make-up strategies being proposed – such as “temporary” or “targeted” price level targeting – could suffer from time inconsistency issues relating to the challenge of central banks to pre-commit to a specific policy promise. A final consideration: AIT would be undermined if it were implemented without specifying the steps that would be taken to bring about inflation overshoots.

Our bottom line: The actual impact of a change in the Fed’s monetary policy playbook may only be a shadow of what AIT and other make-up strategies promise on paper – unless the change in the strategy comes with an upward adjustment to the inflation target itself.