Fed Mulls Raising Inflation Expectations to Boost Economy
Federal Reserve policy makers may want Americans to expect inflation to accelerate in the future so they spend more of their money now.
Central bankers, seeking ways to boost flagging growth after lowering interest rates almost to zero and buying $1.7 trillion of securities, are weighing strategies for raising inflation expectations as well as expanding the balance sheet by purchasing Treasuries, according to minutes of the Fed’s Sept. 21 meeting released yesterday.
Some Fed officials are concerned that expectations of lower inflation will become self-fulfilling, damping demand by increasing borrowing costs in real terms, the minutes said. By encouraging Americans to believe prices will start rising at a faster pace, the Fed would reduce inflation-adjusted interest rates and stimulate the economy. Chairman Ben S. Bernanke said in 2003 that Japan could beat deflation by using a “publicly announced, gradually rising price-level target.”
“The Fed is on the verge of actively targeting a higher inflation rate,” said Dan Greenhaus, chief economic strategist at Miller Tabak & Co. in New York. U.S. stocks advanced, sending benchmark indexes to five-month highs, the dollar fell and gold declined for the first time in three days after the minutes were released.
Trying to raise inflation expectations is untested in the U.S. The policy may backfire if actual inflation drifts higher than the Fed would like, potentially eroding gains won in the early 1980s by former Fed Chairman Paul Volcker, who raised interest rates as high as 20 percent to subdue prices.
“The theory is elegant, but it’s unclear in practice whether short-term moves in inflation expectations really drive real growth,” said Dean Maki, chief U.S. economist at Barclays Capital Inc. in New York and a former Fed researcher.
Jim O’Sullivan, global chief economist at MF Global Ltd. in New York, said in a Bloomberg Television interview that the biggest risk is “boosting long-term inflation expectations more than they lower real interest rates.”
Bernanke on Oct. 15 will deliver a speech on “Monetary Policy Objectives and Tools in a Low-Inflation Environment” at a conference at the Fed Bank of Boston. Some of the panels at the conference will deal with Japan’s experience of deflation.
The Sept. 21 statement saying the Fed “is prepared to provide additional accommodation if needed” was meant to accord “with the members’ sense that such accommodation may be appropriate before long,” the minutes said. The Standard and Poor’s 500 index is up 2.6 percent since Sept. 21 and rose 0.4 percent yesterday to 1,169.77.
The Thomson Reuters/University of Michigan consumer confidence survey showed consumers expect an inflation rate of 2.2 percent over the next 12 months in September, the lowest in a year and down from 2.7 percent in August.
The Fed gave several options for raising short-term price expectations, including providing more information on the inflation rate policy makers consider consistent with their long-term goals and targeting a path for the price level. For the first time, the Fed said it could also target a path for nominal gross domestic product, which isn’t adjusted for inflation.
“The minutes are one of their key communication tools, but it’s not clear what that approach will be,” Maki said.
The report provides more detail on the timing and components of potential easing actions without giving the amount of any additional asset purchases by the Fed. Since the meeting, weaker-than-forecast job growth in September and comments by policy makers, including New York Fed President William Dudley, have fueled speculation that the central bank will soon start a second wave of unconventional easing.
Projection for Purchases
Goldman Sachs Group Inc. economists are projecting that the Fed will announce $500 billion of purchases at the next meeting Nov. 2-3.
“They’re still ironing out the details,” said Chris Low, chief economist at FTN Financial in New York. At the same time, “if we don’t get an announcement in the next meeting I think we’d see quite a bit of disappointment in the bond market and the stock market,” Low said.
Bond traders expect the Fed’s actions to generate higher prices. Their inflation expectations for the next five years, measured by the breakeven rate between nominal and inflation- indexed bonds, rose to 1.47 percent from 1.2 percent on Sept. 20, the day before the Fed’s meeting. Gold prices hit a record $1,366 an ounce on Oct. 7.
Removing Punch Bowl
“The bottom line is, they are trying to reflate, and the market is concerned that historically they have always been late in removing the punch bowl,” said Richard Schlanger, a vice president at Pioneer Investments Inc. in Boston who helps oversee $18 billion. “We are going to be very judicious in our asset allocations here.”
Moderate growth and 9.6 percent unemployment are curbing price gains, prompting U.S. central bankers to warn for the second time in a decade that inflation is too low.
Inflation, measured by the personal consumption expenditures price index, minus food and energy, has been below the Fed’s goal for five consecutive months. The price measure rose 1.4 percent for the 12 months ending August. Prices excluding food and energy have gained at a 1 percent annual pace in the three months through August.
The European Central Bank and Bank of England are among central banks that target an inflation rate through monetary policy. The Fed, by contrast, has no formal inflation objective; instead, Fed officials state a long-run inflation rate they see as consistent with achieving the legislative mandates of stable prices and maximum employment.
The FOMC could adopt a combination of inflation targeting and price-level targeting to get inflation expectations up, said Mark Gertler, a New York University economist and research co- author with Bernanke.
The Fed could restate its commitment to keep inflation rising annually at around 1.7 percent to 2 percent. At the same time, the FOMC could announce some tolerance for inflation above that goal to make up for recent undershooting of those rates, Gertler said.
That would help convince the public that the Fed wasn’t going to raise rates rapidly if inflation moved above 2 percent, he said. Such a strategy “tells the market that the farther we undershoot, the more aggressive we are going to be,” he said.
A nominal GDP target is “a pretty unlikely outcome,” Gertler said. “I don’t think it is on the table as a serious proposal.”
The Fed’s consideration of price-level targeting may draw on research co-written by Gauti Eggertsson, a New York Fed researcher, and Michael Woodford of Columbia University. Eggertsson attended the FOMC meeting last month, his second since joining the Fed in 2004.
Eggertsson and Woodford said in a 2003 paper that a publicly announced price-level target is better than targeting the rate of inflation as a way to increase expectations. Bernanke cited their work in a 2003 speech about monetary policy in Japan.
Woodford said in an interview it would be “desirable” for the Fed to commit to keep rates low to ensure prices rise along a path identified by the central bank.
If people expect higher inflation, “that’s a reason to spend more,” said Woodford, who as a professor worked with Bernanke in the Princeton University economics department.
Japan, by contrast, tied its low-rate policy last decade to an inflation rate instead of the price level. Woodford declined to discuss his talks with Fed officials.
Dudley, who serves as FOMC vice chairman and is the only regional Fed president to vote at every meeting, said in an Oct. 1 speech that, for example, “if inflation in 2011 were 0.5 percentage point below the Fed’s inflation objective, the Fed might aim to offset this miss by an additional 0.5 percentage- point rise in the price level in future years.”
“There’s some evidence that inflation expectations are playing a role both in limiting demand and keeping prices low,” FTN’s Low said.
“You look at housing now and one of the reasons people aren’t buying is they expect they can get a better price if they wait,” he said. “If that behavior spreads into other markets, it could be a real problem.”
To contact the editor responsible for this story: Christopher Wellisz at firstname.lastname@example.org