(Bloomberg Businessweek) -- As Jerome Powell prepares to take over as chairman of the Federal Reserve on Feb. 5, some of his colleagues are publicly agitating for a radical rethink of the central bank’s playbook for guiding monetary policy. Behind the push for reconsideration of the Fed’s 2 percent inflation target: a fear of running out of monetary ammunition in the next recession.
With interest rates near historically low levels—and likely to remain that way for the foreseeable future—these officials worry the Fed will have little leeway to aid the economy when a downturn inevitably hits. They argue that revamping the inflation objective beforehand could help counteract that. “The most important issue on the table right now is that we need to consider the possibility of a new economic normal that forces us to reevaluate our targets,” Federal Reserve Bank of Philadelphia President Patrick Harker said in a Jan. 5 speech.
Any change in the Fed’s approach would of course have major implications for financial markets and the economy. While Powell has yet to say whether he thinks the topic is worth a deep dive by the Fed, former Chairman Ben Bernanke predicted at a high-powered Brookings Institution conference on Jan. 8 that it would come up for “serious debate” at the central bank in the next year to 18 months. Lawmakers may also want to weigh in, which could complicate any remodeling effort.
A variety of proposals are already making the rounds. All aim in one way or another to generate higher inflation on average than the current regime. Since the 2 percent target was instituted in January 2012, inflation has come in below that level for 66 out of 72 months. To achieve higher inflation, the Fed might have to keep interest rates lower for longer and push unemployment down further. But the ultimate goal would be to lift interest rates in tandem with increasing inflation to provide more room to cut rates in the event of a recession.
Here’s a rundown of the options being discussed:
1. Raise the inflation target
Simple and straightforward, such a step would explicitly recognize that a 2 percent price objective may no longer be optimal in a world of low interest rates. The downside is that it could mean a permanently higher level of inflation and would raise questions about the credibility of the Fed’s commitment to its target. If it changed it once, why wouldn’t it change it again?
Of course, there’s the question of whether an institution that’s struggled to hit a 2 percent target can nudge inflation higher than that.
Among the advocates of this idea are former Minneapolis Fed President (and Bloomberg columnist) Narayana Kocherlakota, Nobel Prize winner Paul Krugman, and Laurence Ball of Johns Hopkins University.
2. Adopt a target range for inflation
If the range were centered at or near 2 percent—1.5 percent to 3 percent, for example—it wouldn’t represent a big break from the current framework and therefore wouldn’t call into question the Fed’s inflation-fighting credibility. It would also acknowledge an economic reality: The Fed doesn’t have the ability to precisely hit a specific inflation target. There is the risk, though, that targeting a range instead of a fixed point could breed confusion about exactly what the Fed is aiming for.
Supporters of this approach include Boston Fed President Eric Rosengren, former central bank Vice Chairman Alan Blinder, and Charles Plosser, former president of the Philadelphia Fed.
3. Institute a price-level target
This would commit the Fed to achieving a 2 percent annual rise in prices over an extended period of time. So if inflation runs below target for a while, policymakers would seek to make up for that by engineering commensurate price increases above 2 percent. And vice versa. No country uses this method, but some economic models say it works best. Among its proponents are San Francisco Fed President John Williams and Lars Svensson of the Stockholm School of Economics.
In practice, though, this strategy might be difficult to explain to the public and could result in inflation that varied more widely over time. In its purest form, it would also require the Fed to tamp down inflation below 2 percent—thus risking a recession—if price rises ran above that level for a time.
4. Establish a target for nominal gross domestic product
A close cousin of price-level targeting, this strategy would have the Fed set a goal for the growth of nominal GDP—which unlike real GDP isn’t adjusted for inflation. (So if inflation rises 2 percent and real GDP rises 4 percent, then nominal GDP goes up 6 percent.) Economists who are big on the idea—a group that includes George Mason University’s Scott Sumner, Harvard University’s Jeffrey Frankel, and Bennett McCallum of Carnegie Mellon University—argue that it would leave the Fed better positioned to deal with economic shocks such as the Great Recession because it would commit the central bank to make up for combined shortfalls in output and inflation.
One drawback of this approach is that it risks mystifying a public that has little if any familiarity with the concept of nominal GDP. Besides, the data are published quarterly—in contrast, inflation statistics come out monthly—and are often revised. Another downside: The Fed could meet a 6 percent nominal GDP target through a combination of 3 percent inflation and 3 percent economic growth or 5 percent inflation and 1 percent growth. That’s a big difference.
While the budding debate over the monetary framework won’t reach fruition for a while, it may end up affecting interest rate decisions in the near term, according to St. Louis President James Bullard. In the interim, it “would suggest leaning toward inflation somewhat in excess of the stated inflation target to make up for past misses on the low side,” he said in a Jan. 10 presentation to the CFA Society of St. Louis.
To contact the author of this story: Rich Miller in Washington at rmiller28@bloomberg.net.
To contact the editor responsible for this story: Brendan Murray at brmurray@bloomberg.net, Cristina Lindblad
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