The Committee will maintain the target range for the federal funds rate at 0 to 1/4 percent and continues to anticipate that economic conditions, including low rates of resource utilization, subdued inflation trends, and stable inflation expectations, are likely to warrant exceptionally low levels for the federal funds rate for an extended period.As well, the FOMC voted to keep its QE2 program of long-maturity Treasury purchases intact. There will be essentially only one more opportunity for the FOMC to meet (April 26-27) before the QE2 program ends (the June 21-22 meeting is essentially irrelevant for the program), so the net purchase of $600 billion in long Treasuries by the Fed during the period of early November 2010 to June 2011 seems assured.
In Bernanke's Congressional testimony, he makes the case that inflation, and forecasts of inflation, are low:
FOMC participants see inflation remaining low; most project that overall inflation will be about 1-1/4 to 1-3/4 percent this year and in the range of 1 to 2 percent next year and in 2013. Private-sector forecasters generally also anticipate subdued inflation over the next few years.3 Measures of medium- and long-term inflation compensation derived from inflation-indexed Treasury bonds appear broadly consistent with these forecasts. Surveys of households suggest that the public's longer-term inflation expectations also remain stable.Thus, the consensus projection of the FOMC is that the inflation rate should continue to be below the Fed's 2% implicit (explicit?) target, even two years out, in spite of an extended period with the interest rate on reserves at 0.25%, and the large expansion in the size of the Fed's balance sheet. Here I'm inferring that "extended" could mean as much as two years.
While it is certainly true that there is nothing alarming on the inflation front if we look at what forecasters are predicting and the yields on TIPS, maybe we should examine some other evidence. What's the goal here? Fed people, including Bernanke, make vague statements about a 2% inflation rate being what the Fed is shooting for. But what does that mean? Do we set the target at 2% in January and then say that we achieved our goal if the year-over-year inflation rate as of the next January falls between 1% and 3%? If we exceed the target are we going to have a lower inflation target for a while? I thought about the costs of inflation earlier, in this post, and would make the case that price level targeting might work well. Suppose, for example, that our target price level path is 2% inflation forever. Then, intervention by the Fed which always aims to hit the target path within a relatively short period of time (say a quarter or two) should minimize the uncertainty in real interest rates over any horizon. I think real interest rate uncertainty is a key cost of variable inflation, if not the primary one. Most debt is denominated in nominal terms, default is costly, and uncertainty is costly. Just ask Paul Krugman.
So, suppose for the sake of argument that we are shooting at a two-percent-inflation price level path, and take January of 2007 as our base year (no particular reason). The first chart shows the 2% price path target and the actual paths for some standard price level measures: headline cpi, the core cpi, and the personal consumption expenditure (pce) deflator.
In the chart, you can see that headline CPI inflation is about 1% above target, core CPI inflation is about 1.5% below target, and pce deflator inflation is about on target. Of course, what the Fed should do in this context depends on what measure of inflation it wants to focus on. The Fed, and many economists, make the case that we should focus on some core inflation meausure, either core cpi, or the pce deflator with food and energy prices stripped out. The argument is either that movements in volatile prices tend to be temporary, so we should ignore them, or an appeal to New Keynesian ideas, whereby we only care about the sticky prices, which are the non-volatile ones. Bernanke, in his Congressional testimony, takes the first route:
...the most likely outcome is that the recent rise in commodity prices will lead to, at most, a temporary and relatively modest increase in U.S. consumer price inflation...My concerns here are the following: (i) Maybe these price increases are not temporary; with the world economy coming back (problems in Japan aside) and very strong growth in some places, resources in the world are becoming increasingly scarce. (ii) Inflation is inflation. I make the case here for looking at broader measures than core price indices. (iii) Public relations: What people see is headline inflation; indeed the prices they observe most frequently are food and energy prices. If the Fed speaks to core inflation, it can end up looking devious.
What about the future? What causes inflation? Some people, including Christina Romer, think that inflation is all about Phillips curves. According to these people, if we get more inflation than we bargained for, that would be no problem. In their view, we have a long way to climb up the Phillips curve, a huge output gap, and plenty of spare capacity. Of course Christina and her fellow Phillips-curve types seem to want to ignore the 1970s. The mid-1970s US economy was of course not identical to what we see today, but some of the same factors were at play. Recently there has been a runup in commodity prices, real GDP and employment have taken a hit, and there is an accommodative Fed working in the background, all of which were also true of the mid-70s. That earlier period of course demonstrated the prescience of what Milton Friedman said in 1968, which was that the Phillips curve was not a structural relationship that could be exploited by policymakers.
Now, Milton Friedman also said some other things. He said that "inflation is everywhere and always a monetary phenomenon," which I think is correct. Friedman was off-base though, in terms of another thing he said in 1968, which was that we could get good results if central banks were to target the growth of monetary aggregates. Unfortunately we tried that, and it did not work. Central banks have found that what works well is to target some overnight interest rate over very short periods of time (which seems to efficiently absorb very short-run shocks), and some of those central banks manipulate the overnight interest rate target to achieve some medium-term inflation target.
So why am I saying that Friedman was right about money being the source inflation? Ultimately, it is the demand and supply of outside money - reserves and currency - that determines the prices of goods and services in dollars. The problem is that the demand for outside money fluctuates in unpredictable ways. This problem is even more acute for the US, as some large and unknown fraction of US currency is not held domestically.
So what has been happening to the stock of outside money? As you might imagine, given the QE2 program, the stock of reserves is now a lot larger than in November, as you can see in the next chart. The increase since early November is about $400 billion (2/3 of the total asset purchases planned), or 154.2% at annual rates. Milton Friedman would of course think this was massive, but we have now become accustomed to seeing massive quantities of reserves on the liabilities side of the Fed balance sheet. We recognize that reserves that just sit overnight are roughly like Treasury bills, and need have no inflationary consequences if the reserves are retired in the future, for example by reversing the asset purchases.
What about the stock of currency? That has been growing substantially as well, though what we are seeing may or may not alarm you. In the last chart, you can see that the stock of currency has been growing at an increasing rate, indeed at an annual rate of 10.6% since the inception of the QE2 program. If sustained, and assuming constant velocity and 4% GDP growth, we would get something approaching 7% inflation, which I think would start to make people unhappy.
Ben Bernanke says not to worry, though. In his Congressional testimony we get:
We have all the tools we need to achieve a smooth and effective exit at the appropriate time. Currently, because the Federal Reserve's asset purchases are settled through the banking system, depository institutions hold a very high level of reserve balances with the Federal Reserve. Even if bank reserves remain high, however, our ability to pay interest on reserve balances will allow us to put upward pressure on short-term market interest rates and thus to tighten monetary policy when required. Moreover, we have developed and tested additional tools that will allow us to drain or immobilize bank reserves to the extent needed to tighten the relationship between the interest rate paid on reserves and other short-term interest rates. If necessary, the Federal Reserve can also drain reserves by ceasing the reinvestment of principal payments on the securities it holds or by selling some of those securities in the open market. The FOMC remains unwaveringly committed to price stability and, in particular, to achieving a rate of inflation in the medium term that is consistent with the Federal Reserve's mandate.So, what could go wrong? Plenty.
1. All of the necessary conditions are there for a substantial inflation. I'm thinking of something on the order of 5% to 10%, and once it gets going it will be costly to stop it. The total stock of reserves will rise to about $1.6 trillion by the end of June, and that represents an accident waiting to happen. Right now, as Bernanke points out, financial markets are taking the Fed at its word. The margin between TIPS yields and nominal Treasury yields is not very large, reflecting modest anticipated inflation. But if people start to anticipate that the Fed will not be reducing the size of its balance sheet any time soon, and start to anticipate higher inflation, then nominal rates of return on assets will rise, making reserves undesirable to hold. The Fed can make reserves more desirable to hold by increasing the interest rate on reserves, thus cutting off the incipient inflation, but it will have a hard time doing that. Unemployment may still be high and employment growth slow, and the Fed may not want to be blamed for slowing the recovery. Further, the Fed has locked itself into a portfolio of long-maturity assets which will drop in value if short-term interest rates go up substantially. Ultimately, the Fed may not have the stomach to fight the inflation, in which case the higher anticipated inflation becomes self-fulfilling.
2. Bernanke makes it sound like the Fed has a lot of tools. Surely with so many tools, things have to work, right? However, there are really only two instruments that matter in these circumstances: the interest rate on reserves, and the quantity of assets in the Fed's portfolio.
3. If all hell breaks loose, there could be conflict on the FOMC. With a positive stock of excess reserves in the system, it is the interest rate on reserves that matters. The fed funds rate target is irrelevant. But the Board of Governors sets the interest rate on reserves. What if the Board and the regional Fed Presidents who vote on the FOMC disagree? What happens then?
Ben Bernanke wants you to think that everything is OK. Policy is proceeding in a normal fashion. We understand what is going on. I think the truth is that he is making it up as he goes along. The Fed has undertaken a risky experiment. I can see ways in which this will not turn out OK. Maybe I'm wrong, and that would be good.