Could a central bank maintain public faith if it announces a goal, misses it for more than four years, then say it wants to change it?
San Francisco Federal Reserve Bank President John Williams has asked his colleagues to start thinking about ways to push away from the zero boundary on interest rates. One strategy: Raise the Fed's inflation target from 2 percent currently, to, say 3 percent.
Williams's call for new thinking is timely. Central bankers around the world are coming to the view that the interest rate that keeps the economy's supply and demand in balance is lower now. As a result, rate cycles will peak at lower levels, giving central banks less room to cut before they hit zero. That limits their ability to rescue an economy from recession and rising unemployment without resorting to unconventional tools that bring a suitcase full of their own problems.
"The most direct attack,'' Williams wrote in an essay that included other options, "would be for central banks to pursue a somewhat higher inflation target.''
While it sounds easy, the political and practical aspects of raising the inflation target are challenging. Here are three reasons why:
The mandate to achieve stable prices comes from lawmakers, and it would be unthinkable for the Fed to pursue a higher inflation target without advice and consent from Congress.
"Securing consent would be a very high hurdle,'' said Sarah Binder, a senior fellow at the Brookings Institution, who is co-authoring a book on the Fed and Congress.
Republicans, as they have already, could raise a ruckus over the central bank's discretionary powers, and Democrats would naturally worry that wages might not rise in tandem with prices, undercutting consumer purchasing power. "You can't do it if Congress is going to turn around and try to repudiate it,'' Binder added.
We asked Representative Bill Huizenga, the Michigan Republican in charge of the Monetary Policy and Trade Subcommittee of the House Financial Services Committee what he thought of the idea.
"Changes to an established rate, such as the inflation target, should be done in a transparent manner with the consultation of Congress, not solely by the Federal Reserve,'' Huizenga said in an e-mailed statement. He also said adjusting the target "does not represent a sound long-term strategy aimed at strengthening our nation's monetary policy.''
It's an under-appreciated fact that the current Fed chair is not friendly toward inflation, Charles Plosser, the former Philadelphia Fed president, said in an interview. "My personal opinion is that Janet doesn't like inflation,'' Plosser said.
He should know. He was on Yellen's subcommittee that did the background work to propose the inflation target in 2012 when she was vice chair. Raising the inflation target "would certainly be a tough sell for her'' and probably several other Fed officials, Plosser said. Such a significant change in strategy can't happen if the leadership is not behind it, and if there isn't near unanimous support from all Fed presidents and governors.
Inflation is a game of trust between the public and the central bank. Judging from measures of inflation expectations tracked by the New York Fed, the public does have confidence that the central bank won't allow inflation to run away even though it has kept interest rates at very low levels for nearly a decade. Just how strong their confidence is in the central bank's ability to push inflation higher in a measured way is another question. Three-year-ahead inflation expectations are sloping lower.
Announcing a new, higher target before you have even hit your previous target could dangerously undercut public confidence in the ability to achieve it unless it was accompanied by more quantitative easing or pledges of a longer period of near-zero rates. If those actions failed, the whole regime could unravel.
"If you go out and start changing the inflation target because it is inconvenient then it ceases to be a commitment; you undermine the credibility of the central bank,'' Plosser said.
Williams's message is that central bankers face new challenges now and strategy must evolve. However, "I don't think the Fed is going to be the first central bank to do this,'' said Joseph Gagnon, a senior fellow at the Peterson Institute for International Economics in Washington and a former member of the U.S. central bank's Division of Monetary Affairs. Central banks in smaller economies such as New Zealand were pioneers in inflation targeting and are most likely to be the first to experiment with goal revisions. The Bank of Canada is researching the benefits of a higher inflation target, ahead of a renewal of a policy agreement with the government due by the end of the year. Governor Stephen Poloz has said the bar is high for major changes because the system has worked well.