Once a year in late August, Federal Reserve policymakers travel to Jackson Hole, Wyoming to discuss their latest thoughts and papers on monetary policy. This year, there is an emerging debate concerning how monetary policy should be undertaken, and whether the current thought process should be revised.
President of the Federal Reserve Bank of San Francisco John Williams has stated that the Fed’s 2 percent inflation target requires some rethinking, and likely needs to be higher. His proposal revolves around whether to allow inflation to run above the standard 2 percent target, or completely pivot policy benchmarking away from inflation targeting. The reasoning? The natural rate of interest—the theoretical federal funds rate that neither heats nor cools the economy—has fallen to an exceedingly low level. In theory, a higher inflation target implies a higher long-run fed funds rate, or a way to avoid being trapped at a near zero fed funds rate.
While this is a logical critique of the current thinking around monetary policy, it may be a difficult pill for many to swallow, because it doesn’t jive with the thinking of the past several decades. Allowing for inflation to rise beyond the 2 percent target—and do so intentionally—is anathema to the post-Volcker world.
But Williams should not be written off without a careful examination of his two primary critiques of current Fed policy: first, a low inflation target is not useful in a low interest rate environment. Secondly, fiscal policy should be more countercyclical. While these may not seem closely related, the combination of the two could have profound implications for U.S. monetary policy.
Behind the Williams argument is a desire to reduce overall policy reliance on unconventional tools, as well as an implicit acknowledgement that, regardless of whether or not the inflation target is moved higher, unconventional policies will be used far more frequently than in the past. The primary benefit of raising the inflation target is that—eventually—it should allow the Fed a higher fed funds rate. This gives the Fed a first line of defense to combat future recessions and shocks and—ultimately—less unconventional tactics.
Williams’s confession that the United States is in a low interest rate regime is similar to an argument and framework built by his colleague at the St. Louis Fed, James Bullard. A onetime hawk, Bullard has now pivoted to a “regime-based” model that implies that the Fed should only hike once. In Bullard’s framework, the current economic conditions are likely to persist in the United States. While their arguments are by no means identical, both point toward policy prescriptions of low interest rates over a longtime horizon.
With two Fed presidents vocally stating that monetary policy needs to be rethought (and in exceedingly dovish ways), it is worth noting that the topic of the conference is “Designing Resilient Monetary Policy Frameworks for the Future.” The discussion may be fortuitously timed. After all, with Williams and Bullard challenging the traditional thinking of modern monetary policy, the frameworks discussed may be more nuanced and less traditional than those currently utilized.
Both a weaker dollar and higher oil prices are likely to place upward pressure on inflation at some point, but it will only be a temporary phenomenon. By moving the inflation target higher, the Fed will allow for more absorption and less reaction to currency and oil shocks.
The question is whether or not the remaining members of the Fed will begin to drift in Willams’s and Bullard’s direction. At the very least, the Fed is moving toward a more dovish, more inflation tolerant center. And at the most, moving toward a new thought process around how to implement monetary policy in a low rate world.
Changes to policy targets and style do not happen quickly, but—if the trend is moving in the direction of Bullard and Williams—the Fed will absorb much higher inflation without worrying about the consequences. Simply, if the Fed adopts a significantly higher inflation target, it is implicitly—or explicitly—announcing interest rates will be persistently lower for much, much longer.
Samuel Rines is the Senior Economist and Portfolio Strategist with Avalon Advisors in Houston, TX.
Image: Dollar bill. Flickr/Tom Bullock