The FOMC Sticks Out Its Neck - Again

The FOMC meeting that took place over the last two days was an important one. The first big piece of news is in the FOMC statement in this paragraph:

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.

The previous statment from December read as follows:

The Committee also decided 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 mid-2013.

So, policy is now to be more accommodative. Presumably something changed. Somehow the state of the world must look worse in some unexpected way on dimensions the Fed cares about. What could it be? In the first paragraph of the current statement, we learn that the recovery is proceeding, perhaps more slowly than might have been anticipated a year or two ago, but maybe a little more quickly than was expected at the last FOMC meeting. Inflation has decreased slightly, but the Fed had expected that, and the inflation rate is increasing in terms of core measures. So why the policy change? Why indeed?

This is a very risky policy move. By the end of 2014, the interest rate on reserves (IROR) will have been at 0.25% for more than six years. The Fed has never made such a commitment before, and they have no clue what will happen as a result. Here is what could happen. Months from now, a year from now, or whatever, banks may get the idea that bank reserves are a less attractive asset to hold. That would be triggered by better relative returns on alternative assets, which in turn could simply be the result of an ultimately-self-fulfilling higher inflation rate. Banks will start to abandon reserves and prices will rise. What should the Fed do under those circumstances? It should increase the interest rate on reserves to curb the inflation. But it committed today not do that. Everyone understands this, and that's what will get the inflation going. Once higher inflation really becomes entrenched, it's hard to get rid of. How do we get rid of it? Well, we know all about that, as some of us had to live through it in the early 1980s. Time for another recession.

This is a replay of the August 2011 decision, except worse. Recall that Fisher, Kocherlakota, and Plosser were opposed on that round, and note that Lacker dissented this time around. Kocherlakota's argument for dissenting last August was that the policy change was inconsistent with the FOMC's previous behavior, and the same argument applies here. Best guess is that Fisher, Kocherlakota, Plosser, Lacker, and perhaps others, are opposed this time around. That would be a serious disagreement, with some astute economists on the nay side.

The FOMC also released a statement that is supposed to clarify how it thinks about policy. This is notable in at least two respects. First, the FOMC is expanding the dual mandate:

The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates.

"Maximum employment" crept into the FOMC's language in recent times, but now they are entering into new territory by taking ownership over long-term interest rates. Here, the first law of central banking comes into play: Don't take responsibility for something you cannot control. A central bank controls an overnight interest rate, and any interest rate - like the interest rate on reserves - that it sets administratively. Sometimes, like now, that amounts to the same thing. Though in pre-Accord times the Fed could successfully peg long-term bond rates, it would be incorrect to say that this can be done under typical conditions. Indeed, under current conditions, though the Fed seems to think that its quantitative easing (QE) operations can move long bond rates, it is fooling itself.

The second piece of important information in this latter statement is:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

So now we have an explicit statement that the Fed's inflation target is 2%, as measured by the rate of change in the pce deflator (raw). That's not an explicit inflation target, as they make it clear that the dual mandate applies - they will tolerate more inflation if employment is lower than "maximum employment," whatever that is, and vice-versa.

The Fed is now also releasing more information on its forecasts, available here. These seem pretty optimistic on the inflation front. FOMC participants are not only forecasting close-to-zero short-term nominal interest rates for years in the future, they are also forecasting inflation rates well below 2% for three years and more into the future. I would love to see the models (and the add factors) that produce those forecasts.

Here's what we see in the data. The chart shows the pce deflator, the Fed's preferred price level measure, going back to January 2005, as compared to a 2% trend beginning at the same time. In level terms, we are now on the high side by about 2%. You have to be creative about the base period to find a case where the actual pce deflator is below the 2% growth path. Thus, it's hard to say that inflation is too low relative to its 2% target path. Given recent history, and the projection for monetary policy the Fed is going on, how could anyone be predicting inflation rates as low as 1.5% over the next several years? You tell me.

Here is another piece of information that will either make you laugh or cry. The release of information about the Fed's forecast was supposed to give us some inside information on what the Fed is thinking so that we can feel more secure. In Figure 2 of the forecast summary, we see when the FOMC participants predict "policy firming." Six participants seem more-or-less sensible, and are predicting firming in 2012 or 2013. But there are another six who are not predicting firming until 2015 or 2016. Now I'm not feeling more secure. I want to panic, because those people seem to be incompetent.