The Federal Reserve’s “Review of Monetary Policy Strategy, Tools, and Communications” (or Framework Review) is principally about assessing strategies for making monetary policy more effective at the zero nominal bound (ZNB). This is motivated by the expectation that a lower neutral rate will lead to the policy being constrained more frequently by the ZNB, by the flatness of the Phillips curve, and by the prospect that inflation expectations may become adaptive if inflation gets stuck well the central bank’s objective or remains below the objective for an extended period.1In this case, a central bank may not be able to achieve its inflation objective. This has been the case for the BOJ for some time, and this problem may now be troubling the ECB. This is the crisis in central banking.
What’s the Problem?
There are two parts to this problem: (1) a flat Phillips curve; and (2) inflation objectives becoming adaptive.
The Phillips curve is not everyone’s cup of tea. But to raise inflation back to the 2% objective, central banks have relied on it, as they must, because (in my view) the Phillips curve is the principal link between monetary policy and inflation. But the Phillips curve is widely appreciated to have become very flat. As a result, it is no longer as effective or reliable a transmitter of monetary policy to inflation as it was in the past.
If inflation expectations become adaptive, or more adaptive, and are no longer well anchored at the inflation objective, those expectations will move in the direction of lower inflation and even become anchored at that lower rate. Should that happen, a central bank may find itself unable to achieve its inflation objective. Hence the importance attached to inflation expectations by the FOMC, and specifically as a focus of the Review, as emphasized by Vice Chair Clarida:
“A flatter Phillips curve makes it all the more important that inflation expectations remain anchored at levels consistent with our 2 percent inflation objective.”
However, monetary policy has been much more successful in boosting aggregate demand and lowering the unemployment rate to near or below its natural rates than in raising inflation back to its objective. So, the
1I refer to the ZNB for the Fed rather than the more widely used effective lower bound (ELB) because the FOMC has, at this point, taken negative rates off the table. With respect to Japan and the euro area (which we discuss as examples of the crisis in central banking), the constraint would more appropriately be referred to as the ELB rather than the ZNB.
the crisis is principally related to the challenge of reaching central banks’ inflation objectives. That’s the flat Phillips curve and unanchoring of inflation expectations.
The Evolution of the Phillips Curve:
The Increased Importance of Expectations
The flattening of the Phillips curve is not the only evolution in that relationship relevant to this discussion.
Research from the San Francisco Fed decomposes the contributions to inflation dynamics in a Phillips curve framework of persistence, slack, and expectations over the last 20 years.2 The research suggests that, as the Phillips curve has become flatter, the contributions of persistence have declined and those of expectations have increased. Less persistence means that any downward shock to inflation today does not feed into inflation tomorrow as much as otherwise. The larger contribution from expectations means that, to the extent that those expectations are anchored, consumers are more likely to view such inflation shocks as temporary.
The BOJ and the ECB: Examples of This Crisis?
This challenge for central banks has been painfully evident in Japan for some time and now has apparently infected the euro area economy.
Japan is the prototype of this challenge, one it may not be able to overcome. “Core-core” inflation remains close to zero. And, despite admitting that inflation expectations have become very adaptive, the BOJ appears to believe that it can convince markets that it can and will achieve the inflation objective (indeed, overshoot it), rising inflation expectations and thereby actual inflation to the objective or above. Unlikely in the extreme.
In the euro area, the period during which inflation has been persistently well below its 2% (or a bit lower) objective has been much shorter than for Japan. Nevertheless, core inflation seems stuck at 1% or even below. The last reading was 1.1%. Measures of inflation expectations in the euro area have eroded as well, suggesting that the euro area may be headed to–or already be in–the same circumstances as Japan.
Is the U.S. Immune?
Of course not. After all, core PCE inflation has been below the 2% objective since the recession (with the exception of two brief periods), is likely to end this year below 2%, and is generally to be no higher than 2% in 2020. On the other hand, the three weak readings early this year have pulled down the 12-month reading. From that point forward, the monthly data show a compound annual rate slightly above 2%, and core PCE inflation is expected to be close to 2% in 2020. Of course, that’s just a forecast!
2 See Òscar Jordà, Chitra Marti, Fernanda Nechio, and Eric Tallman, “Why is Inflation Low Globally,” FRBSF Economic Letter, July 15, 2019; and Òscar Jordà, Chitra Marti, Fernanda Nechio, and Eric Tallman, “Inflation: Stress Testing the Phillips Curve,” FRBSF Economic Letter, February 11, 2019.
It is harder to judge how well-anchored inflation expectations are in the U.S. A range of measures inform policymakers’ judgment, and how well-anchored inflation expectations are is in the eyes of the beholder. Clarida has good eyes.3 He said in May:
“As I assess the totality of the evidence, I judge that, at present, indicators suggest that longer-term inflation expectations sit at the low end of a range that I consider consistent with our price stability mandate.”
The 5-10 year inflation expectations measure from the Michigan survey reading was 2.6% at that time, but it had been bouncing around between 2.3% (it’s historical low) and 2.6%. Today, it is back to 2.3%. The five-year-five-year forward BEI rate was 1.85% at that time. It has bounced around since and is about 1.7% today. Inflation expectations are perhaps a bit softer today.
What Can Central Banks Do?
Obviously, responding early enough and aggressively enough to downturns to limit any cyclical decline in inflation will help a lot. That is an obvious conclusion and one already reached in the Review. But given the ZNB, it will still be a challenge to increase aggregate demand enough to limit the decline in inflation, keep inflation expectations anchored, and return to the objective within some reasonable period. That means
• a preemptive and aggressive response with rates;
• rapidly easing to the ZNB if the economy seems to be sliding toward recession; and • quick and aggressive use of unconventional policies.
The objective of the Review is to make monetary policy even more successful at the ZNB, specifically by preventing inflation expectations from becoming adaptive and collapsing to the lower actual rate. Clarida, for example, said, in relation to the Review:
“Persistent inflation shortfalls carry the risk that longer-term inflation expectations become poorly anchored or become anchored below the stated inflation goal. In part because of that concern, some economists have advocated ‘makeup’ strategies under which policymakers seek to undo, in part or in whole, past inflation deviations from target.”
There is little room for conventional policy to respond to downturns and some skepticism about the power of the unconventional policies central banks have implemented at the ELB. The flat Phillips curve has made it challenging for central banks to raise inflation to its objective. At the very least, the challenge is accomplishing that soon enough to prevent inflation expectations from becoming adaptive and collapsing toward the low inflation rate. This is the crisis in central banking.
3 Richard Clarida, “Sustaining Maximum Employment and Price Stability,” Federal Reserve Board, May 30, 2019.
A crisis leaves the BOJ with little prospect of returning to 2%. That crisis may now be confronting the ECB. The U.S. is in a better place, but we still have not achieved our inflation objective for eight years, and inflation expectations may arguably have softened some. The Review hopefully will lead to innovations in strategy that will make unconventional policies more effective, in turn contributing to keeping inflation expectations anchored.