What should be on the agenda in Chicago?23rd February 2019
The Fed plans to hold a conference in Chicago during June, with the goal of developing improved tools, targets and strategies. Obviously the major issue will be how to deal with the zero bound, which is expected to reoccur during the next recession. In my view the second goal should be to develop procedures that avoid the mistakes made during 2008 (before the zero bound was hit), which were acknowledged in Bernanke’s memoir.
One key lesson from the Great Recession is that when rates are zero it’s very difficult to be too expansionary. Almost everywhere in the world, at all times in history, central banks at the zero bound adopt policies that in retrospect look too contractionary. Contemporaneous fears of inflation prove groundless. So that’s one important lesson.
Next recession, the Fed needs to immediately stop paying IOR and be far more aggressive with QE than last time. We know that inflation isn’t the real problem at the zero bound. A recent Yahoo article suggests that bond yield pegging is another option being considered:
Fed officials would also reassess how well their policy toolkit worked in combating the deep recession that followed the financial crisis of 2008-09, and consider what additional tools might be added to prepare for the next downturn. He mentioned a crisis-time policy implemented by the Bank of Japan, which would seek to establish a temporary ceiling for Treasury debt yields at longer maturities, as a tool that might be considered.
That’s a reasonable option, but it’s not enough by itself. Indeed, doing more concrete steps at ultra-low interest rates is not enough, as ultra-low interest rates represent a sort of prediction of policy failure, a prediction that NGDP will grow too slowly to achieve the Fed’s dual mandate. The goal should be to prevent the zero bound from occurring in the first place, not just to deal with it appropriately. Once you are there, you have already (accidentally) adopted an inadequate policy.
One option for avoiding the zero bound it to raise the inflation target, but the Fed has ruled that out:
In reviewing its fundamental strategies, Clarida made clear the Fed wouldn’t change its target for inflation from the current 2 percent level. Policy makers would consider, however, whether the central bank should introduce a strategy that seeks to make up for periods of below-target inflation with periods of above-target price rises.
Level targeting is the sort of regime that makes it less likely you’ll hit the zero bound, but the devil is in the details. A promise to do whatever it takes to get back to the price level trend line in 10 years is far less effective than a promise to get back there in 4 years. Partly because the quicker rebound is more expansionary, and partly because it’s more credible that the Fed chair would still be around in 4 years.
Although I’d prefer 4% NGDPLT with no 2% inflation target, it is possible to combine NGDPLT with a flexible 2% inflation target, which puts weight on both inflation and employment. You simply set the NGDP target equal to 2% plus the Fed’s estimate of trend RGDP growth, and adjust the growth estimate periodically to reflect new estimates of trend RGDP growth. That’s not as good as a simple NGDP level targeting (inflation actually doesn’t matter), but it still gets you 95% of the benefits of NGDPLT and it’s also consistent with the Fed’s interpretation of its inflation mandate. Inflation will average 2% in the long run.
Ironically, the regime I just proposed would probably get you closer to a 2% long run trend rate of inflation than our current inflation targeting regime, which has repeatedly missed on the low side and then let “bygones be bygones”.
As noted, they also need to learn from their mistakes of 2008, and for that I recommend more reliance on market forecasts. I certainly don’t expect them to talk about NGDP futures markets, but recommending that the Treasury issue bonds indexed to NGDP growth might be a modest first step. Perhaps the NGDP bond payoffs could be based on the third GDP announcement, which occurs roughly 3 months after the quarter ends. That data is fairly complete, although of course there are occasionally later revisions as well.
The BLS might be instructed to keep two GDP series when there is a major definitional change (such as adding software to investment), to allow an internally consistent series for bond indexing. That’s a bit messy, but these major definitional changes don’t occur very often. Don’t let the perfect be the enemy of the good.
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