Most central banks adopted Inflation Targeting when inflation was a real problem. The purpose of such a regime is to increase credibility, accountability and transparency for monetary policy and to permanently bring inflation to a pre-agreed target. The Fed decided to adopt such a regime at a time when inflation is not really a problem. Why would it do that?
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Finally, the FED bit the bullet and is now almost officially an Inflation Targeting central bank. I say almost because it does not formally embrace the Inflation Targeting framework. It does not have a policy horizon for the its target and it will not publish an Inflation Report. On the other hand it does publish forecasts for GDP, inflation, interest rates and unemployment. Only one or two other IT central banks publish forecasts of the interest rate path. Although the FED justifies its decision as a move towards more transparency it could blow up in its face. Unlike inflation, interest rates are used in day to day transactions and surprise deviations from the announced path could have real effects in the economy.
Nevertheless, it seems that now the FED follows a model where it steers the interest rate in response to deviations of inflation, output and unemployment from some target. A lot of targets for one single instrument if you ask me and it could create confusion.
The first example is the positive reaction of financial markets to the latest FOMC release. Here is the entire document and this is what it said in a nutshell:
- “economy has been expanding moderately,”
- “the unemployment rate remains elevated. “
- “growth in business fixed investment has slowed,”
- “Inflation has been subdued in recent months, and longer-term inflation expectations have remained stable. “
Pretty gloomy if you ask me. This information should have sent any investor running for the hills. But then it said this:
“To support a stronger economic recovery and to help ensure that inflation, over time, is at levels consistent with the dual mandate, the Committee expects to maintain a highly accommodative stance for monetary policy. In particular, the Committee decided today to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that economic conditions–including low rates of resource utilization and a subdued outlook for inflation over the medium run–are likely to warrant exceptionally low levels for the federal funds rate at least through late 2014. “
At this point the “crowd” went wild. From the reaction of financial markets you would think that up until now the FED has not been doing anything. Unfortunately this is not true. The fed has been doing everything and more. The latest move is the FED’s of saying: ALL IN.
The main question is if it would work. I have my doubts and here is why.
First graph shows real GDP growth and real GDP in billions USD. The green line shows the average real GDP growth for a period of 6 yrs. I use this period as since 1947 there have been 11 recessions or 1 every 6 years, almost.
The interesting part in this graph is the fall in average growth over the 6yrs period since 2000. What is interesting to see is that the economy in 2010 and 2011 has behaved much like in 1982 delivering growth above the average for the business cycle.
Let’s look now at real GDP growth versus the PCE measure of inflation. Once again after the drop in 2008 PCE inflation has recovered and is now sitting above the target of 2%. However, trend inflation has been falling since the 1980s and thus it was easier to bring it into deflation than it would have been in 1980.
The main reason put forward by critics of the FED is the high unemployment rate. It is true that unemployment remains elevated. I am not sure how much more can the FED do here. As you saw above GDP is growing above the average for the business cycle and inflation is above the 2% target.
And now the scary part. The FED has just committed to a highly accommodative policy until 2014. Also, the FED has been criticized that it has not done enough. The graph below paints a different picture. The FED has dome more than enough if you compare the real GDP growth with M1 (money supply) growth.
In the last three years the FED has been doing everything it could to bring the economy out of recession. And in my view it has done a good job. Critics point to unemployment but that is really too much to ask from the FED. It will take sometime for unemployment to fall especially since the average real GDP growth has been declining in US since 2000. Pouring money in the economy will not solve this problem. My view is that job creation is linked to the fear that taxes will have to rise in the future. We will just have to wait on this one.
Until then, for the short term markets received their “sugar rush”. At first their reaction does not make sense as markets should not get so excited when the FED tells them that all that is a ahead is a period of “moderate expansion”. But if you shorten the horizon and you put your “trader” hat on then you get it. We are playing the same game as we played since 2008. Central banks deliver short term funds that are used for short term gains. Nothing gets to the real economy in the form of business investment and it will not happen irrespective if the FED decides to do QE3, QE4 and beyond.
However, I suspect that there is another facet to the latest move from the FED. It could well be that Bernanke is shouting to the world that there isn’t anything else he can do. In the best case scenario 7 years of highly accommodative monetary policy will deliver 2% real growth and 7% unemployment. And I have a feeling that this is for the most part the reason for why the FED adopted IT. It wants the clearly show the world that is out of ammunition.
Here is something to think about: if that is the best case scenario then what is the worst case scenario for 7 yrs of highly accommodating monetary policy?
P.S. The trend is in the eye of the beholder. The graph below shows that if we use HP econometric technique to filter real GDP we have an interesting result: RGDP level is above trend.