Why We Can’t Take Inflation Hawks Seriously

Peter Coy at Bloomberg reports on the Shadow Open Market Committee. Not surprisingly, the SOMC fears an outbreak of inflation is just around the corner.

Conservative economists are paying attention to the man behind the curtain and not liking what they see. At a meeting in a Manhattan hotel on Nov. 20, the so-called Shadow Open Market Committee criticized Federal Reserve Chairman Ben Bernanke for an ultra-easy monetary policy that will, in their opinion, lead ultimately to dangerously higher inflation.

It is almost comical that those who profess to be experts on monetary policy appear to almost never listen to what Federal Reserve officials say. Case in point:

Marvin Goodfriend, an economist at Carnegie Mellon University, said the Federal Reserve “appears to be walking away” from a commitment it made last January to keep the inflation rate at or near 2 percent. In September, when it announced a new round of bond buying to bring down unemployment, the Fed made no mention of the 2 percent target, merely saying it would pursue its growth target “in a context of price stability.”

Made no mention of the 2 percent target? Really? Let’s go to the tape:

Consistent with its statutory mandate, the Committee seeks to foster maximum employment and price stability. The Committee is concerned that, without further policy accommodation, economic growth might not be strong enough to generate sustained improvement in labor market conditions. Furthermore, strains in global financial markets continue to pose significant downside risks to the economic outlook. The Committee also anticipates that inflation over the medium term likely would run at or below its 2 percent objective.

I think they were pretty clear about the 2 percent target, which is the Fed’s definition of price stability. If Goodfriend can’t remember this, he should bookmark the appropriate page on the Board’s website:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate.

The only way this isn’t clear is if you are deliberately ignoring what the Fed is saying. The SOMC also fears any policy that allows inflation to drift even temporarily above 2 percent:

Jeffrey Lacker, the hawkish president of the Federal Reserve Bank of Richmond, was the Shadow Open Market Committee’s invited keynote speaker. He shared the committee members’ concerns about letting inflation drift much above the 2 percent target in the name of growth, even for a short while.

“At the very least, the precedent set by an opportunistic attempt to raise inflation temporarily is likely to cloud our credibility for decades to come,” Lacker said.

First, actual inflation outcomes would be expected to fall in a symmetric pattern around 2 percent. When Lacker argues against allowing even a temporary drift above 2 percent, he is effectively saying that 2 percent is a ceiling, not a target, so that on average, inflation will be less than 2 percent over time (all the errors would be on the low side of the target). Thus, he is actually trying to enforce a price stability standard stricter than the current standard. Second, this whole discussion is something of a strawman to begin with. Realistically, only Chicago Federal Reserve Chairman Charles Evans supports any meaningful drift over 2 percent. Even Minneapolis Federal Reserve President Narayana Kocherlakota, much lauded for his move to the dovish side of the FOMC, sets an upward bound of just 2.25 percent before the Fed should consider a policy shift. And Federal Reserve Vice Chair Janet Yellen, also a well-noted dove, describes an optimal path for policy that foresees inflation just barely kissing 2.25 percent at best. In short, within the Fed there is very little support for any inflation drift that would “cloud our credibility for decades to come.” This is simply a nonsensical fear on Lacker’s part.

Next, we have the argument that we will never see inflation coming because of the Fed’s large scale asset purchase program:

Mickey Levy, chief economist for Bank of America and an SOMC member, said that the Fed “has neutralized the bond vigilantes” by keeping rates low. In other words, even if bond traders are worried that inflation will heat up, they don’t dare bet that way by driving interest rates higher, because the Fed will swat them away by pushing rates back down. “The adage ‘Don’t fight the Fed’? It’s in full force,” Levy said.

Do people forget that both the BLS and the BEA publish monthly reports on prices? That the Fed would not incorporate this data into their decision making process? That the Fed cannot control inflation expectations as measured by the TIPS market, the very same expectations the Fed uses as a policy guide?

There will still be plenty of data and market indicators even within the context of bond purchases. Here is my expected sequence of events: If growth or inflation accelerates to the point that the Fed will be expected to change policy, bond market participants will bid down the price of Treasuries holding constant a given pace of asset purchases (that “all else equal” thing). The Fed will then have a choice – either prepare to tighten as the market expects, or accelerate the pace of asset purchases to hold rates down. If they choose the second route, the bond sell-off will accelerate as participants begin to suspect the Fed is not committed to the 2 percent target. That would be the signal the Fed is clearly moving in the wrong direction. And you should expect inflation to move higher. In other words, the Fed’s bond purchase program does not by itself eliminate inflation signals should such signals emerge. The bond vigilantes have not been neutralized by the Fed; they have been neutralized by reality.

Finally, back to the 2 percent target:

The Shadow Open Market Committee meeting wrapped up just before Bernanke spoke a few blocks away at a meeting of the Economic Club of New York. Harvard University economist Martin Feldstein, who attended the SOMC symposium, was given the privilege of asking Bernanke questions at the Economic Club luncheon. He did not choose to ask the chairman whether the Fed was walking away from its 2 percent inflation target.

Right after the luncheon, though, Bloomberg TV’s Mark Crumpton asked Feldstein, who was President Ronald Reagan’s chief economic adviser, if he was concerned that the Fed hadn’t been talking about the 2 percent target lately. “Absolutely,” Feldstein said. “It’s very important for the Fed to reaffirm those goals.”

Notice that Feldstein claims the Fed is not discussing the target moments after Bernanke spoke. But what did Bernanke actually say? To the tape:

But with longer-term inflation expectations remaining stable, the ebbs and flows in commodity prices have had only transitory effects on inflation. Indeed, since the recovery began about three years ago, consumer price inflation, as measured by the personal consumption expenditures (PCE) price index, has averaged almost exactly 2 percent, which is the FOMC’s longer-run objective for inflation. Because ongoing slack in labor and product markets should continue to restrain wage and price increases, and with the public’s inflation expectations continuing to be well anchored, inflation over the next few years is likely to remain close to or a little below the Committee’s objective.

How has the Fed not been talking about the 2 percet target? They repeatedly emphasize the target. Bernanke does so virtually every time he speaks. Cleveland Federal Reserve President Sandra Pianalto basically says the 2 percent target is so concrete that there should no longer be a distinction between hawks and doves. How can Feldstein sit through Bernanke’s speech and completely miss the part that addresses Feldstein’s concerns? How can he not say “the Fed talks about 2 percent every chance they get”? The only explanation: He simply does not want to recognize any information that departs from his pre-conceived view of the world.

Bottom Line: Inflation hawks continue to operate in a parallel universe.

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