Monetary policy options for handling very low inflation
The FOMC’s longer-run inflation objective of 2 percent seeks a balance between inflation being far enough away from zero to make the threat of deflation low, and inflation being low enough to mitigate many of the economic distortions associated with high inflation. An inflation rate of only 1 percent therefore falls short of meeting the right balance between these tradeoffs, especially in the current policy environment.
Basic macroeconomics and a large body of research suggest that central banks should ease monetary policy when inflation falls below or is expected to fall below the central bank’s inflation objective. But since December 2008, the FOMC’s primary monetary policy tool, the federal funds target rate, has been at 0 to ¼ percent—what is effectively the zero lower bound on nominal interest rates. Thus, there exists a limit on the extent to which monetary policymakers can provide additional accommodation through normal channels.
As a result, the FOMC has been using other policy tools to provide additional monetary accommodation. These include large-scale asset purchases (buying large volumes of an expanded set of eligible securities on the open market) and forward guidance on future interest rate policy (providing information about future policy decisions). Countering a hypothetical adverse shock to the economy that slowed the pace of recovery or pushed the economy into recession would require using these other policy tools to an even greater extent than the FOMC has so far.
Making its way toward 2 percent
In thinking about how policy should respond to very low inflation today, the forecast for inflation’s future trajectory plays a crucial role. A forecast of falling or continued stagnant inflation would call for different policy actions than a forecast of rising inflation.
Recent historical behavior is often a good predictor of future inflation. But inflation expectations, economic slack, and a host of other factors influence the inflation process as well and can offer some insights into where inflation is likely to be in the future.
A forecast of falling or continued stagnant inflation would call for different policy actions than a forecast of rising inflation.
In evaluating these factors, the news has been reasonably encouraging. For starters, take inflation expectations. Over time, inflation expectations help to anchor the inflation process; that is, inflation tends to return to its expected rate.
There are a variety of ways to measure inflation expectations based on surveys of consumers, professional economists, and businesses; implicit measures of inflation derived from financial markets; and combinations of the two. Most of these measures show that longer-term inflation expectations have been roughly stable for some time (figure 10).
The Cleveland Fed’s longer-term inflation expectations series had been running at low levels throughout 2012 and the first part of 2013. But more recently, these inflation expectations have moved closer to 2 percent. The relative stability of long-run inflation expectations provides one reason to think that the recent low inflation readings are likely to be temporary.
A second factor likely to lift inflation going forward is a generally improving economy. The economy has grown at a moderate pace since the end of the recession, but this steady growth has reduced the amount of idle resources and general slack in the economy. The labor market continues to recover from the recession, and over the course of 2013 the unemployment rate fell by more than 1 percentage point and nonfarm businesses’ payrolls expanded by more than 2 million workers.
With inflation expectations remaining stable, the economy continuing to grow, and some of the transitory factors that weighed on inflation in 2013 unlikely to be repeated, most forecasters call for a gradual rebound in inflation over the next few years. In their assessment in March 2014, participants on the FOMC forecasted that PCE inflation would likely step up by the end of 2014 and continue to rise in 2015 and 2016 until it neared the FOMC’s longer-run inflation objective of 2 percent (figure 11).
Thus, the most likely outcome for inflation is not further disinflation or outright deflation, but rather a gradual increase in the rate of inflation. Because inflation in the future depends partly on monetary policy decisions today, such a projection suggests that policymakers believe that today’s policy settings are appropriate to return inflation to the level that the FOMC has determined is most consistent with the goal of price stability.
Of course, forecasts are inherently uncertain, and this is especially true for inflation. What could occur that would generate a higher or lower inflation trajectory? One possibility is a supply disruption in a major oil-producing economy that causes the price of oil to soar, producing much higher inflation than what is currently anticipated. A sharp pick-up in the pace of economic growth could also produce higher inflation, as firms become more confident in their ability to raise prices to offset rising costs of production.
But shocks are also possible that would drive inflation lower than anticipated, such as a renewed downturn in the economy from a collapse in consumer confidence. One Cleveland Fed forecasting model suggests that the most likely inflation rate by the end of 2015 will be around 1.7 percent, but the uncertainty surrounding this projection is high: The model suggests there is a 70 percent probability that inflation will be between 0.25 percent and 3 percent (figure 12). So clearly policymakers will have to watch the data closely to see that inflation actually does evolve in the desired fashion.
A symmetric inflation objective
The range of possible outcomes in figure 12 makes clear that inflation could either sharply accelerate or remain at very low levels for some time; in other words, the risks to the inflation outlook are two-sided. Either of these scenarios would likely warrant a monetary policy response. Recent post-meeting statements show that the FOMC is committed to mitigating deviations of inflation on both sides of its longer-run objective, consistent with a symmetric inflation objective.
With the federal funds rate target already set to the range of 0 to ¼ percent, providing additional monetary accommodation to combat fears of further disinflation would likely require using other policy tools. One possibility could be asset purchases—beginning a new program of purchases of long-term assets if the current program has ended or picking up the pace of purchases if the current program has not yet ended. Alternatively, monetary policymakers could impose strong forward guidance on the target for the federal funds rate, suggesting that the target would not change until inflation returns to a certain level. Imposing such an inflation “floor” could add accommodation automatically if the inflation outlook were to weaken, which would help stimulate the economy and bring inflation back toward the floor.
The FOMC is committed to mitigating deviations of inflation on both sides of its longer-run objective.
At the same time, the FOMC is prepared to remove accommodation quickly to combat a surge in inflation, if that were to become necessary. Thus far, the historically large size of the Federal Reserve’s balance sheet has failed to cause high inflation rates, an experience shared over a longer time span by the Bank of Japan. But a large balance sheet can complicate the process of raising policy rates. To this end, the FOMC has new tools—such as the term deposit facility, fixed-rate overnight reverse repurchase agreements, and the payment of interest on excess reserves—to assist in the withdrawal of monetary accommodation at the appropriate time and pace in order to help achieve its goals of maximum employment in the context of price stability.
This essay has explained why low inflation can turn into “too much of a good thing.” Our analysis suggests that today’s low inflation is primarily the result of the economy taking a long time to recover from the severe recession of 2007–2009. Over the long run, the Federal Reserve has the tools to keep inflation from running too high as well as too low. And over the past 30 years, it has a solid history of doing just that. These factors, along with the progressively improving economy, lead us to conclude that inflation is on a course to gradually reach the FOMC’s 2 percent objective.
All data cited in this essay are as of March 27, 2014.
For more analysis of the research mentioned in this essay, visit Inflation Central at www.clevelandfed.org/inflation-central. There, you can also find up-to-date estimates of inflation expectations and much more.
“Behind Recent Disinflation: 2010 Redux?” by Edward S. Knotek II and William Bednar <http://www.clevelandfed.org/research/trends/2013/0713/01infpri.cfm&62;
“Forecasting Implications of the Recent Decline in Inflation,” by Todd E. Clark and Saeed Zaman <http://www.clevelandfed.org/research/commentary/2013/2013-15.pdf>
“Forecasting Inflation? Target the Middle,” by Brent Meyer, Guhan Venkatu, and Saeed Zaman <http://www.clevelandfed.org/research/commentary/2013/2013-05.pdf>
“The Future of Inflation,” by Joseph G. Haubrich <http://www.clevelandfed.org/research/commentary/2011/2011-20.pdf>
“What’s Up in Inflation? Shelter and OER,” by Edward S. Knotek II and William Bednar <http://www.clevelandfed.org/research/trends/2014/0314/01infpri.cfm>
“When Might the Federal Funds Rate Lift Off? Computing the Probabilities of Crossing Unemployment and Inflation Thresholds (and Floors),” by Edward S. Knotek II and Saeed Zaman <http://www.clevelandfed.org/research/commentary/2013/2013-19.pdf>