The Fed faces a difficult inflation framework

PALO ALTO, Calif. (Reuters) – Federal Reserve policymakers fear being ill-equipped to face the next recession as part of their current inflation targeting strategy, and are embarking this year on a an effort to define new interest rate management strategies around the world. moderate inflation and low borrowing costs.

But for central bankers and US monetary policy experts who met Friday in Palo Alto to discuss the options available, the challenge was clear: not only will it be difficult to define a better framework before the next recession and determine how to explain it. to the public so that it really works will be a major challenge.

Indeed, just to explain their ideas to each other, policy makers and academics at the Hoover Institution's annual conference posted slide after slide, filled with equations, dead spots and almost indecipherable graphics.

And while most economists with PhDs in the audience presumably understood theories, "I think the assumptions are not quite in agreement. Are the assumptions of the model really true? "Said Loretta Mester, President of Fed Bank, in an interview of the conference.

In other words, what will really work?

When central banks around the world turned to unconventional tools such as bond buying and forward-looking guidance to combat the 2007-2009 financial crisis, they thought they faced unique conditions .

But ten years after the end of the Great Recession, it is clear that the Fed faces a new economic norm. Neither inflation nor interest rates should increase significantly, even if the US unemployment rate is at its lowest level in 50 years.

This leaves the central bank with much less leeway to reduce interest rates to stimulate the economy in the past.

This year, while the US economy is at a standstill, interest rate policy is on hold and the expansion is expected to reach a record length this summer, Fed policymakers believe they have some margin of to find a way to make policy more effective. the next recession where the shock comes.

Among the ideas: to commit to offsetting periods of low inflation with periods of higher inflation than the goal; rely on simple policy rules to eliminate uncertainties in rate decisions; and use negative interest rates to force companies to invest and banks to lend in times of economic downturn.

SHOCK ABSORBERS FOR A NEW WORLD

According to their advocates, all would act as buffers to alleviate economic weakness and shorten recessions.

Each would be different, to greater or lesser degrees, from the Fed's current approach, which aims for 2% inflation and an ill-defined ideal of full employment.

And everything would critically depend on the understanding of the framework by households, businesses and financial markets and their response accordingly.

The average targeting of inflation is the framework option that has garnered the most support so far. The idea, according to Fed Chairman in New York, John Williams, is to aim for an average inflation of 2% over a given period, say a year and a half.

When inflation declines in times of economic stress, the central bank reacts by maintaining an easy policy until inflation exceeds 2% and stays there for a while.

If households and businesses know they can count on higher inflation in the future, they will borrow and spend more in a recession, which in theory would accelerate the return to health of the economy. But for the plan to work, investors will have to believe that the Fed will actually increase inflation in the future.

Negative rates would stimulate the economy by punishing companies that do not put money into the economy; if they keep their money in the bank, they will pay for the privilege. For such a scheme to be accepted, however, ordinary citizens must be certain not to be punished.

The political rules reinforce the credibility of the Fed by setting a clear path for economy-based rates, said Mester of Cleveland Fed. But if these rules are applied too rigidly, they will not give the desired results by the Fed.

Not all conference attendees were convinced of the benefits of a new framework, not even the Fed's decision makers who presented some of the ideas.

"The bar of change is high," said Mary Daly, director of the Fed in San Francisco. "It can be expensive to make mistakes in this space."

St. Louis Fed Chief James Bullard has gone further: Experimenting with how the world's largest central bank conducts business would "create chaos" in global financial markets.

Nevertheless, the group seemed to want to explore new ideas and the Fed organized a half dozen additional events around the revised framework planned for the rest of the year.

Most viewers acknowledged that the Fed had the merit of tackling the problem. Andy Levin, professor of economics at Dartmouth College, "The Fed must find something new."