Can the Fed lose control of inflation?
Flexible inflation target for monetary policy: just new wine in old bottles? –
One should use old language images sparingly. And yet: The future target zone for inflation rates recently proposed by Jerome Powell, the head of the Federal Reserve (Fed), possibly combined with an increase in the average rate of price increase targeted by the Fed, is very reminiscent of one by the Deutsche Bundesbank in the 1990s model practiced very successfully. At that time, however, the focus was not on the inflation rate itself, but on the growth rate of the money supply.
Numerous media reported about it as early as the end of July 2020: the announcement by Jerome Powell that in the future "the price increase in the USA may be higher than two percent for a while if it has been below it for a longer period of time" (Wiebe, 2020). The ECB has also been dealing with this topic, at least since the summer of 2019: “Among other things, the question is whether the current price target for the period after the crisis is still appropriate. [Former] ECB President Mario Draghi prefers a “symmetrical approach”. The central bank would have more leeway and could accept an upward or downward deviation of two percent from the target value over a longer period of time ”(NTV, 2019). The idea of Jerome Powell, but also of Mario Draghi, gives monetary policy greater flexibility because, as before, it does not have to react immediately with interest rate increases (interest rate cuts) when the economy is overflowing (declining). On the contrary: If, after a long period of weakness (boom phase), inflation should (again) rise (fall), key interest rates could still remain low (high) in order to ensure the stability of economic growth. "The more flexible approach would mean that there would be no automatic rate hikes when we reached two percent, said foreign exchange expert Thu Lan Nguyen of Commerzbank" (NTV, 2019).
Now all of these formulations are still rather vague. Much more precise information is required for a specific design of the proposal. After all, ECB Council member Eberhard Nowotny has leaned out the window a little more clearly than others: He was in favor of maintaining the two percent target, "but with a corridor of 0.5 or one percent up or down" (NTV, 2019). With such a definition at the target level, however, the instrument level is still insufficiently described. When speaking of a price increase rate of 2 %1 as the targeted average, at least the question arises, "which past periods should be offset within which later period" (Wiebe, 2020). It is not only the length of the (past and future) periods of time that plays a role, but also whether strict symmetry is sought: Should the period of time when the periods are exceeded correspond to that of the periods below?
Jerome Powell also presented his perspective on the new level of instruments in Jackson Hole in July 2020. While the control of the interest rate level remains the first instrument level of the Fed, attempts are to be made on a second level to stabilize inflation expectations through the existence of a corridor. If, for example, a long-term, significantly too low rate of price increases (Wiebel, 2020) threatens to depress inflation expectations, the corridor opens up the prospect for market participants that future overruns will be tolerated. This would tend to stop the downward slide in inflation expectations. In the opposite case, the corridor prevents inflation expectations from drifting upwards. The stabilization of inflation expectations is in turn in this concept a key task or an intermediate goal of modern central banks in order to have inflation itself as an end goal under control and to keep it.
However, such a plan only works (well) if certain prerequisites have been clarified. If, for example, an average inflation rate of 2% is sought and the symmetry solution outlined above (about two periods in the past and two periods in the future) is to be used, very different scenarios are conceivable: In the first case, let us assume that in the past Inflation rates of -1% and +1% (mean 0%) have occurred. Then one could “afford” inflation rates of 1.5% and 6.5% for the future (mean value 4%). Because when you look at it together (the mean value of 4% and 0% is 2%), the central bank could point out that it had “on average” (ie over four periods) reached an inflation rate of 2%. In a second scenario, inflation rates of -0.5% and +0.5% (mean value 0%) in the past and of 3% or 5% (mean value 4%) in the future should apply. Here, too, the central bank could report “execution” with a clear conscience. But would private households behave identically / similarly in both scenarios? Hardly likely! This is due to the fact that there are clearly different extreme values or variances in both scenarios. The spread in the first scenario is very large at 7.5%, while in the second scenario it is significantly lower at 5.5%. The wider the corridor, the less it is considered binding by the public. In order to maintain its reputation, the central bank would have to cut the corridor quite narrowly, as in Nowotny's proposal, otherwise it is not very credible.2 Finally, let us examine the corridor proposed by Nowotny using an example that illustrates the expected effects: In This third scenario with a narrow corridor of plus / minus 1%, for example, should inflation rates of 1% and 1.5% (mean 1.25%) in the past and of 3% and 2.5% (mean 2.75%) %) will apply in the future. Here, too, the central bank could point out that (the mean of 1.25% and 2.75% is 2%), “on average” (ie over all four periods) it has achieved an inflation rate of 2%. But: the narrower the corridor, the more likely it is that target violations are conceivable, if not even probable: even then, the central bank's credibility suffers. A real dilemma.
Contrary to what was previously assumed, the central bank can also choose an asymmetrical solution. Then the following applies: The more asymmetrical the distribution to the detriment of the past and in favor of the future - the more time monetary policy gives itself to correct the missed targets in the past in the future - the lower the binding effect of the corridor with regard to the desired anchoring of the Inflation expectations. The same applies to the duration or number of correction periods as a whole: a central bank makes itself implausible if it promises to achieve an average target for the inflation rate, but only if one looks at the whole thing over many, many years. The aim is to find a corridor that is as symmetrical as possible and that promises an optimal width / spread in connection with a moderate time horizon. Not exactly child's play, not even for savvy central bankers.
But that's not all: B. not just any, but a very specific form of expectation formation in the private sector. These are neither adaptive nor rational expectations, i.e. those expectation formation hypotheses that are used in most macroeconomic models (and thus also in the research departments of the major central banks). In the best case, “confident expectations” must be present.3 These were theoretically developed in connection with the money supply strategy of the Deutsche Bundesbank (1948 to 1998) only in 1998 (Maaß and Sell, 1998), although the private sector is under the German regime The Bundesbank is likely to have behaved accordingly a long time before
The target zone concept of the Deutsche Bundesbank
Since 1974 the Deutsche Bundesbank has set an important role model for many countries in the world economy in their fight against inflation, even if, from today's perspective, it was not quite as successful as the ECB from 1999 to 2009. Until 1998 she set a target for the annual growth of the money supply. As we know today, it has failed to achieve this as often as it did, even when it came to formulating a target corridor for M3. Nevertheless, nobody at home or abroad questioned their extraordinary success in maintaining price level stability. It is therefore advisable to re-introduce the concept of a monetary target corridor, which has been used very successfully by the Deutsche Bundesbank.
In the concept of a monetary target corridor, it was typically and quite deliberately that the corridor announced by the central bank for the development of the money supply was not always adhered to. That is already an essential difference to the Nowotny construction from above. Rather - this is also the experience with the Deutsche Bundesbank - it was repeatedly exceeded or fallen below by the monetary authorities (see Figure 1). Until 1998, however, the Bundesbank never lost sight of its long-term objective - namely maintaining price level stability. 5 So-called transitory target violations - e.g. to accommodate external shocks - were viewed as justifiable in this concept as long as they were in the private sector as was only assessed temporarily and did not lead to a revision of the medium and long-term inflation expectations there. So it was by no means the corridor alone, but the conviction that even leaving the corridor temporarily was not “bad”, which kept inflation expectations stable. However, a destabilization of inflation expectations had to be avoided at all costs. Then not only the reputation of the central bank, but also the inflation rate it is targeting itself (De Grauwe, 1992) would be in jeopardy. For the central bank, therefore, it became an all-important question whether it was able to prevent a possible (disadvantageous) change in inflation expectations in the private sector, even if it itself temporarily deviated from its own announced goals.6 Credibility and transparency had to be provided for this This is exactly what the Deutsche Bundesbank succeeded in doing back then: "monetary targeting provides a means of transparently and credibly communicating the relationship between current developments and medium-term goals" (Mishkin and Posen, 1997, 21). In Figure 1 it becomes clear that the actual money supply growth (M3) in the 1990s repeatedly broke out of the corridors established by the Deutsche Bundesbank. The latter were not consistently constant, but were between (at least) 3% and (at most) 7%. In the 1980s and 1990s in particular, the Deutsche Bundesbank was seen as a haven for price stability.
Growth rate of the money supply M3 and target corridor of the Deutsche Bundesbank (1991 to 1997)
Source: Deutsche Bundesbank, annual report, various years; own compilation.
Central banks can therefore maintain their reputation even if they deceive the private sector (even more than) once; this is always possible if they have successfully sought price level stability over (many) long years.7 The reputation of a central bank is itself a function of the duration of the price level stability it has "established" up to now (Maaß and Sell, 1998; Sell , 1999). Under these conditions, the public expects an appropriate compensatory countermeasure after exceeding (falling below) the money supply corridor. There are then to a certain extent “perverse” adaptive expectations that could also be interpreted as “rational trustworthiness” (“confident expectations”) of the audience. A game or time inconsistency theoretical foundation of this expectation hypothesis can be found in Maaß and Sell (1998).
In detail, "confident expectations" are based on the following hypotheses (Maaß and Sell, 1998, 524):
- Not a single, short-term value of the inflation rate, but only the long-term average inflation rate is a useful indicator of the success of monetary policy.
- Short-term deviations between the realized and the long-term target inflation rate (or from the long-term target corridor for the inflation rate) must be corrected sooner or later. This is best done through a compensatory discretionary monetary policy, which helps to preserve the reputation of a successful central bank.
- Only if the long-term results of monetary policy are approved by the actors involved can the reputation of a successful central bank remain or become high.
If such “confident expectations” exist, it can be shown that - assuming the central bank's optimization behavior in a Barro-Lucas-Sargent-Wallace world8 - a return to high price level stability can be achieved quickly after a “price surprise”, 9 while rational expectations on the other hand result in a persistently high inflation rate (cf. Maaß and Sell, 1995; 1998). Such a result proves the monetarist credo (which is also shared by the ECB at this point), according to which a stabilization of inflation expectations already contributes to the dampening of inflation itself. At the same time, it raises the question of whether the paradigm asserted by the neo-classical theory, according to which the private sector shelves the reputation of the central bank for a long time after a one-time deception, does not lead to economic agents punishing themselves with rational expectations. 10
similarities and differences
What the Deutsche Bundesbank and the major central banks have in common these days is undoubtedly the realization that controlling the inflation rate crucially depends on being able to keep the inflation expectations of the private sector stable. Even the most subtle monetary policy arrangement, including the Powell proposal, must submit to this criterion. Despite the foreseeable differences in construction, it can be seen that the Deutsche Bundesbank continues to play an early pioneering role and also a late role model. An important difference to the policy of the Deutsche Bundebank is undoubtedly that today's modern central banks, such as the ECB and the Fed, are currently dealing with a deflationary, if not partially deflationary environment. In a sense, they are currently hardly given the opportunity to “fall below” their monetary expansion rate. Studies on the effectiveness / efficiency of monetary policy in the large industrialized nations would show that the unprecedented expansion of total assets / central bank money stocks since 2008 has only been crowned with (very) little success, at least with regard to the achievement of the inflation target set by the central banks themselves
If it is true that the reputation of a central bank itself is a function of the duration of the price level stability it has so far created, then the Fed and the ECB, unlike the Deutsche Bundesbank in the past, now have a problem: it has been theirs for the last ten or eleven years failed to convincingly achieve their self-set inflation target. Any future corridor construction would suffer from this lack of reputation. A harmonious interaction between the central bank's target zone and the private sector's “confident expectations” is therefore much less likely than in the case of the Deutsche Bundesbank. While the Bundesbank referred to the use of an instrument (central bank or money supply) in its corridor, Powell's proposal aims to a certain extent at the success indicator for central bank policy, namely the inflation rate itself. This is a more difficult job in that central banks will find it much easier to control the expansion or contraction of their own balance sheets than the level of inflation. As is well known, numerous influencing factors for this variable are still more or less outside the effectiveness of central banks (terms of trade, exchange rate, foreign interest rate, etc.). Compared to the Powell proposal, the concept of the Deutsche Bundesbank had one more degree of freedom, as transitory outbreaks from the target corridor were quite tolerable there. This degree of freedom does not (yet) exist in the Nowotny version of the Powell proposal. It makes sense to either cut the corridor a little further than in the Nowotny approach or to include outbreaks from the narrow corridor in the compensation policy from the outset.
However, even the most elaborate proposals cannot overcome a fundamental problem: We do not know whether there will still be inflation in the future, as in the days of the Deutsche Bundesbank, i.e. until the end of the 1990s. That would put a clear barrier on the expansive part of the compensation strategy for corridor constructs.There are enough arguments that suggest that inflation rates will continue to be low, as they have been since 2009 (Rürup, 2020, 12): Globalization has led to intensified competition, which has restricted companies' scope for price increases. Digitization, in turn, has lowered production costs. Wage price spirals, which were feared by the central banks especially in the 1970s to 1990s, have lost importance and relevance since the unions in many countries, especially in the euro zone, increasingly lost members and bargaining power (Öllinger and Sell, 2017 ).
A look at the past of the Deutsche Bundesbank shows that with the concept of a target corridor for the money supply it not only formulated an operational intermediate goal of monetary policy, but also met the expectations of the public in a special way. Thanks to its long-term success on the inflation front, it was never in serious danger of losing its reputation if the money supply corridor was violated. A similarly motivated target corridor for the inflation rate could become an important element of its monetary policy not only for the Fed, but also for the ECB. In doing so, the ECB should - precisely because of the lack of reputation with regard to meeting its own inflation target - consciously create a direct reference to the policy of the Deutsche Bundesbank in the past, in order to lend a reputation for its future corridor, which it itself will have in the coming ones Years to acquire from the public. The Fed does not have this advantage. The rather rhetorical question in the title of this article about the “new wine in old bottles” can be answered in the affirmative, but that does not lead to a fundamental criticism of the Powell proposal. With a clever elaboration in detail, the quality of current European and US monetary policy can even be significantly improved.
- 1 As Volker Wieland (2020) rightly points out from the German Council of Economic Experts, it is not even clear whether the “Harmonized Index of Consumer Prices” (HICP) used by the ECB is a suitable measure for inflation in the Eurozone to eat. For good reasons (not discussed further here) he prefers the GDP deflator.
- 2 Evidence of this is the development of the exchange rate target areas within the framework of the European Monetary System (EMS) I: After the successful speculative attacks against the pound sterling and other currencies at the beginning of the 1990s, the only way to get around was to significantly expand the parity grid. The topic of hardening the European exchange rate target zone in the direction of a fixed rate system had thus initially become obsolete. Only the later Maastricht criteria forced a lower volatility in the bilateral exchange rates. See Giavazzi and Pagano (1988).
- 3 Under "confident expectations" one understands that errors of expectation with regard to the inflation rate lead to a correction of the inflation expectations, namely to one that behaves inversely to the adaptive expectation hypothesis: while with adaptive expectations the inflation expectations increase with surprise inflation, economic subjects with " confident expectations ”assume that the (temporarily) higher inflation rate will be corrected downwards in the future. If, in fact, exceeding the inflation target is only seen as transitory, the economic agents reasonably expect that the inflation target will be undershot in the future, because (only) in this way the inflation rate targeted by the central bank can be achieved on average.
- 4 EMS I experienced a similar “fate”, which functioned more or less stable as an exchange rate target zone from 1978 to 1998 and whose proof of existence and stability was not “delivered” until 1991 by Paul Krugman (Krugman, 1991).
- 5 "In any event, the Bundesbank was clearly allowing its short-term monetary policy to miss the targets in pursuit of the longerterm goal". Quote from Mishkin and Posen (1997, 28).
- 6 See Maaß and Sell (1995). According to Frankel and Hardouvelis (1985), changes in the price of key commodities that occur immediately after the central bank deviates from its own targets provide it with information as to whether a subsequent correction - back to the previous monetary policy course - is expected in the private sector or whether there new targets of the monetary authorities for the future are presumed.
- 7 "In short, as long as the underlying inflation goal was met over the medium term, the existence of the monetary targets rather than their precise funcionality was sufficient" (Mishkin and Posen, 1997, 27).
- 8 In such a world, the so-called "Lucas criticism" applies, according to which a change in course in monetary or financial policy from the point of view of the acting authorities is expected to result in a corresponding (and undesirable) adjustment behavior of the private sector (households, companies) got to. If, however, short-term violations of goals by the private sector are only interpreted as such and not as symptoms of a real change of course, these (undesirable) adjustment reactions may not materialize.
- 9 In 1994, Laskar (1994) also advocated a target corridor for monetary policy as a lever to counteract time (in) consistent behavior by central banks.
- 10 For the sake of order, it should be admitted that the literature on the time-inconsistent behavior of central banks referred to the so-called “Grimm trigger mechanism” at an early stage. According to this, the future losses of the loss of reputation or the lost benefits from cooperation - if the time preference rate of the private sector is low - can be so high that deceit is not really worthwhile for the acting central bank (Currie and Levine, 1993).
- 11 “The central banks have obviously lost control over the development of the price level.” Quote from Rürup (2020, 12). Instead, asset prices have gone through the roof, combined with considerable regressive effects on the distribution of wealth.
Currie, D. and P. Levine (1993), Rules, Reputation and Macroeconomic Policy Coordination, Cambridge University Press.
De Grauwe, P. (1992), The Economics of Monetary Integration.
Frankel, J. A. and G. A. Hardouvelis (1985), Commodity Prices, Money Surprises and Fed Credibility, Journal of Money, Credit, and Banking, 17(4), 425-438.
Giavazzi, F. and M. Pagano (1988), The Advantage of Tying One’s Hands: EMS Discipline and Central Bank Credibility, European Economic Review, 32(5), 1055-1077.
Krugman, P. (1991), Target Zones and Exchange Rate Dynamics, Quarterly Journal of Economics, 106(3), 669-682.
Laskar, D. (1994), "Time inconsistency" of the optimal monetary policy: a case for target zones, Center d‘Études Prospectives d‘Économie Mathématique Appliquées à la Planification, Working paper.
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NTV (2019), ECB is apparently reviewing its inflation target, July 18, www.n-tv.de/wirtschaft/EZB-ueberprueft-offenbar-ihr-Inflationsziel-article21154364.html (December 28, 2020).
Öllinger, M. and F. L. Sell (2017), What determines union density? A political economy model of the labor market with empirical evidence in the context of European countries, Review of Economics and Finance, 10(4), 18-32.
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Wiebe, F. (2020), New Playroom. The head of the US Federal Reserve announced a more flexible inflation target. For the adjustment he presents a subtle justification, Handelsblatt, July 28, August 32
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Title: Flexible Inflation Target for Monetary Policy
Abstract: This paper analyzes the Federal Reserve’s Jerome Powell’s proposal possibilities and limits made during the recent meeting of central bankers in Jackson Hole, Wyoming, USA. According to Powell, the Fed, as well as the ECB, might change its inflation target policy in the future. The idea is to construct a target zone for the inflation rate. This mechanism would allow the Fed to violate its own inflation target - possibly more than 2% in the future - for certain periods, provided it is committed to compensate for these violations in subsequent periods. The goal, hence, would be to meet the inflation target only on average in each period. This article discusses problems of implementation, compares the plan with the monetary compensation policy of the old Deutsche Bundesbank and assesses its likely failure or success.
JEL Classification: E52, E58, E65
© The author: in 2021
Open Access: This article is published under the Creative Commons Attribution 4.0 International License (https://creativecommons.org/licenses/by/4.0/deed.de).
Open Access is funded by the ZBW - Leibniz Information Center for Economics.
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