The primary "liabilities" currently on the Fed's balance sheet are currency (Federal Reserve notes and coins), reserves (roughly, checking accounts of financial institutions held with the Fed), and reverse repos (ON-RRPs discussed in this post), which play an important role in the Fed's intervention to control overnight interest rates. Currency and reserves are not liabilities in the sense that private debt instruments are liabilities. A corporate bond, for example, is a promise to make a future stream of payments. Currency represents only a promise to exchange one type of note for another - the Fed will exchange new Federal Reserve notes for ones that are worn out, and it stands ready to exchange four fives for a twenty, for example. Not everyone can have a reserve account, but for those institutions that do, the Fed makes some other promises - it stands ready to exchange one unit of currency for one unit of reserves, and vice-versa. ON-RRPs are different, in that they conform to the same rules as private secured debt. In particular, in an ON-RRP transaction, the Fed posts collateral in its portfolio (Treasury securities or agency mortgage-backed securities) to secure loans that are typically made overnight (though the Fed sometimes makes use of term ON-RRPs).
But central bank liabilities are obligations in an indirect sense. That is, the Fed makes promises about the future purchasing power of its liabilities. Central bank liabilities are unique: currency is a medium of exchange which no private financial institution issues, and Fed reserves play a special role in settling large transactions among financial institutions. The Fed has determined that Fed liabilities will perform these roles well if it commits to a 2% target for the annual rate of increase in the personal consumption expenditures deflator (the PCE deflator). That's a promise - a commitment. If the Fed keeps that promise, then this should reduce uncertainty concerning the real value of payments in long-term contracts, and thus make credit markets and the markets for goods and services work more efficiently.
So, how has that been going?this speech by Jim Bullard) that the additional oil price decreases we have seen will further prolong very low inflation.
Added to that is concern about the public's views on future inflation - low inflation uncertainty is part of what we gain from inflation targeting. One measure of expected inflation is the "breakeven rate." A breakeven rate is the difference between the yield to maturity on a Treasury bond, and the yield to maturity on a TIPS security (an inflation adjusted Treasury bond) of the same maturity. For example, the next chart shows 5-year and 10-year breakeven rates:
1. TIPS securities compensate investors for CPI (consumer price index) inflation. But the Fed cares about PCE inflation. The CPI is known to generate an upward-biased measure of inflation.
2. An investor in a TIPS does not make a payment to the Treasury when CPI inflation is negative - inflation compensation goes to zero whenever CPI inflation is less than zero.
3. Breakeven rates can reflect aggregate risk, which is variable over time.
4. Breakeven rates can reflect market liquidity. For example if the TIPS market is less liquid than the market in nominal Treasuries, this will bias the breakeven rate downward as an estimate of expected inflation. And market liquidity can vary over time.
Another measure of anticipated inflation is the 5-year, 5-year forward rate, which is a measure derived from bond yields of the average 5-year inflation rate anticipated 5 years from now:the Atlanta Fed says we shouldn't worry. According to them, if we correct for the biases in standard market-based inflation expectations measures, inflation expectations have been quite stable.
But suppose that the Atlanta Fed is wrong. Or, suppose that the Atlanta Fed is right but, even worse, market participants are wrong and inflation is actually going to stay low, unless the Fed does something about it. But it's not as if everyone is agreed on what "doing something about it" means.
One view of inflation is that it's driven by a Phillips curve process - when output and employment are high, and unemployment is low, inflation is high. Then, the central bank controls inflation in a passive fashion, by leaning against the wind. When the economy "heats up," that produces more inflation, and the central bank cools things down by raising interest rates. When the economy "cools down" that produces less inflation, and the central bank heats things up by lowering interest rates. If this were the way the economy actually works, that would be great. Nothing subtle about it - you could get a group of 8-year-olds to run the central bank.
Here's an example where that idea didn't work: including Naryana, think that backtracking on liftoff would be a good idea for the Fed, given low inflation, and supposing that what we're seeing in market-based inflation expectations measures is measuring what's going on. But the Japanese did that experiment - after the late 1990s they stayed with ZIRP, and inflation just went below zero.
Some have argued that, if extended ZIRP doesn't work, then there are other ways to get inflation up. Again, the Bank of Japan has been doing a great job of doing the required experiments for us. In April 2013, they embarked on a major quantitative easing project, which is reflected in Japan's monetary base as follows:
Another suggestion is that, if all else fails, the central bank's policy interest rate can always go negative. However, theory, and experience, tells us that doesn't work either. The most egregious case is Switzerland, which currently has an overnight interest rate of -0.7%, and an inflation rate of -1.4%.
So, this seems straightforward. If you're a central banker and want to increase inflation, don't model your behavior on a central bank that can't do it. Take as an example someone who's serious about it, and can produce results. Arthur Burns (Fed Chair, 1970-1978), and G William Miller (Fed Chair, 1978-1979) seem to have known the trade. What did they do?