When Federal Reserve officials meet this week, they will despondently confront an economy yet again falling short. Employment growth has flagged. GDP probably grew less than 2% (annualized) in the first half of this year; clouds from Europe, Asia and America’s own “fiscal cliff” darken the second half. The Federal Open Market Committee’s full year forecast of 2.4% to 2.9% looks out of reach.
So what will they do? Much of the street expects some kind of action, a view I share. It would probably come as an extension of “Operation Twist,” the purchase of longer-term bonds in exchange for short or medium bonds already in the Fed’s portfolio. It could stretch this out over a few months or a full year.
This, however, will be fiddling at the edges. What critics say the Fed needs is a wholesale makeover of its goals and methods. Some want the Fed to raise its inflation target. Others would have it adopt a nominal GDP target. Both approaches are intended to induce easier monetary policy that would foster faster growth in employment. At the opposite end of the spectrum, more conservative economists and Republican legislators want to take away the Fed’s responsibility for full employment and have it focus solely on inflation.
Lost in this blizzard of outside advice is the fact that the Fed actually has a new framework of its own. In January it declared that henceforth its long-run target for inflation was 2%. Previously Fed members only stated their long-run preference, which ranged from 1.5% to 2%. It also said it considered its two statutory goals, low inflation and full employment, equally important. Previously, employment was, de facto, subordinate to inflation.
If you haven’t heard more about this, it’s because the Fed has treated the target like an unwanted Christmas gift, still unopened months after the tree has been taken down. The initial announcement was devoid of any hint of radicalism; it didn’t even use the word “target” or spell out the implications of its “balanced” approach to inflation and employment. It felt like the FOMC couldn’t agree on whether it was, or ought to be, a genuine departure. Indeed, the Fed acts as if nothing has changed. Its “appropriate” monetary policy in April yielded forecast inflation of 2% or lower over the next few years. This vindicates critics who say the Fed acts as if 2% is a ceiling, not a target.
If the Fed were conducting policy based on this new framework, inflation would be centered around 2%. Indeed, if the Fed treated employment and inflation equally, it would likely tolerate inflation above 2% given that it is missing its full employment mandate more than its low inflation mandate.
What would such a policy look like? Fortunately, we don’t have to speculate. Janet Yellen, the Fed’s vice-chairman, described one in detail in speeches in April and in June. Ms Yellen uses a fairly conventional monetary policy rule in which the Fed seeks to minimize variations in inflation around its 2% target and in unemployment around its natural rate of 5.5%. In her simulation the Fed, by putting equal weight on its employment and inflation objectives, eases monetary policy more aggressively, keeping the federal funds rate at zero through the end of 2015 (instead of 2014 as currently projected). The result is a much more rapid decline in unemployment. Inflation briefly tops 2%, before returning to 2% over the long term.
This is important because the principle bone of contention between Ben Bernanke , the Fed chairman, and critics like Paul Krugman is over the value of keeping inflation expectations around 2%. Mr Bernanke believes the stability of actual and expected inflation around 2% has been hugely beneficial to society and enhanced the Fed’s operational flexibility. Writing off that investment, he has said, would be reckless. Mr Krugman believes those benefits are vastly outweighed by the good that comes from a higher inflation target, namely that it reduces real interest rates when nominal interest rates are stuck at zero.