A major question among investors after Janet Yellen’s nomination for Fed Chair is whether she will be too soft on inflation. Part of Yellen’s dovish reputation stems from a debate among the FOMC in July 1996, in which she warned the committee about the risks of pushing inflation too low. With the passage of time, however, the views Yellen expressed at that meeting now come across as very sensible. Indeed, today they would be considered uncontroversial among most economists. In reality Yellen is closer to the Fed consensus on inflation than her reputation in markets would suggest.
The debate at the July 1996 FOMC meeting focused on the appropriate long-run goals for monetary policy. At the time, the Fed had a statutory mandate to publish target ranges for monetary aggregates, but in practice they were not used as a guide for policy due to the weak relationship between money growth and inflation. Chairman Greenspan therefore asked the committee to debate how policymakers should interpret and institutionalize the “price stability” mandate of the Federal Reserve Act.
In his opening remarks, Greenspan framed the question as a choice between an inflation target of zero and a price level target that remained stable over time. Governor Yellen, however, used her remarks to argue for a positive inflation objective for the FOMC. She made two main arguments: (1) positive inflation was needed to “grease the wheels” of the labor market due to rigidity in nominal wage contracts, and (2) positive inflation makes it easier for the central bank to lower real interest rates and reduces the risk of hitting the zero lower bound. Later in her career Yellen stressed the same two factors, noting that the first had become less important (due to faster productivity growth) but the second more important (due to the experience of prolonged deflation in Japan). On net she came out in the same place: the Fed should aim to achieve low positive inflation rather than zero inflation. Today this is the formal mandate of most developed market central banks.
Yellen’s dovish reputation on inflation is also belied by her early support of inflation targeting. In early 2006 when Bernanke was about to take over as Chairman, Yellen pointed out that he differed from Greenspan in one important way: he favored an explicit inflation target for the Fed. Yellen sided with Bernanke, and stated on numerous occasions that she favored a target of 1%-2% for the core personal expenditure (PCE) consumption deflator—the midpoint of which is ironically below the 2% target the Fed ultimately adopted. She has reiterated her support for inflation targeting as recently as April: “In terms of the targets, or, more generally, the objectives of policy, I see continuity in the abiding importance of a framework of flexible inflation targeting” (April 16, 2013).
On inflation we therefore expect mostly continuity from the Yellen Fed. She supports run-of-the-mill inflation targeting, much like Bernanke and many other central bankers globally.
A tougher question is how the Yellen Fed would balance its inflation and full employment goals if they came into conflict. We see some room for concern that Yellen would be more tolerant of overshooting the Fed’s inflation target, at least for a time, compared to other Fed officials. This is the implication of the optimal control simulations she presented in a series of speeches last year, for example. She has also made the point that the Fed should err on the side overshooting because it is easier for monetary policymakers to tame inflation than it is to pull the economy out of deflation. Here is Yellen in an April 2012 speech:
“Risk-management considerations strengthen the case for maintaining a highly accommodative policy stance longer than might otherwise be considered appropriate. In particular, the FOMC has considerable latitude to withdraw policy accommodation if the economic recovery were to proceed much faster than expected or if inflation were to come in higher. In contrast, if the recovery faltered or inflation drifted down, the Committee could provide additional stimulus using its unconventional tools, but doing so involves costs and risks. Given the unprecedented nature of the current economic situation and the limits placed on conventional policy by the zero lower bound on interest rates, these issues of risk management take on special importance.”
That being said, it is easy to overstate these inflation risks. First, Fed officials have not actually adopted the optimal control framework, and future inflation considerations are probably a reason for this. New York Fed President Dudley articulated this point in a recent speech:
“Consider a scenario in which the central bank decided to increase monetary accommodation by committing to maintain a low short-term interest rate for a long time even if this commitment resulted in inflation overshooting the central bank’s objective in the future … this is not a policy that has been adopted by the Federal Reserve. There are implementation challenges with this approach. In particular, it is difficult for a monetary policy committee today to institutionally bind future monetary policy committees to follow actions that could conflict with their objectives in the future. Without such a credible forward commitment, such policies would likely be ineffective in affecting expectations in the manner needed to provide additional monetary policy accommodation.”
Second, our guess is that an inflation overshoot would cause the FOMC to revise up its estimate of structural unemployment and dial down accommodation. We do not think Fed officials would continue with aggressive policies to push unemployment down if inflation picked up meaningfully. As the Fed’s statement of long-run goals and objectives makes clear, there is a fundamental difference between the price stability and full employment parts of the mandate. The economy’s inflation rate “over the longer run is primarily is determined by monetary policy,” whereas the level of full employment “is largely determined by nonmonetary factors.” The Fed does not face a tradeoff between its two goals today: unemployment is too high and inflation is too low. They are complementary objectives. But if they do come into conflict in the future, a Yellen Fed would likely give precedence to the inflation goal.
If our reading of Yellen’s views is correct, then inflation becomes a major swing factor for the interest rate outlook. We think Yellen might tolerate some overshooting of the inflation target, but not a sustained miss. Plus, support for continued quantitative easing would likely erode among the rest of the committee with inflation at or above target. Any pickup in inflation would therefore be an early communication challenge for the next Fed Chair.
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