Fed Could Allow Higher Inflation As Interest Rates Remain Low, Papers Suggest

Fed Could Allow Higher Inflation as Interest Rates Remain Low, Papers Suggest

Fed economists say demand for safe and liquid assets such as Treasurys will continue to hold down yields

The Fed’s preferred inflation measure has been moving up in recent months but has run below the target for more than four years.

By

David Harrison

March 23, 2017 12:01 a.m. ET

1 COMMENTS

U.S. interest rates are likely to stay historically low, which should prompt the Federal Reserve to rethink its approach to inflation. Those are the conclusions of two new research papers by teams of Fed economists published Thursday by the Brookings Institution.

Taken together, the two papers conclude that increased demand for safe and liquid assets such as 10-year Treasury notes will continue to hold down yields, making it difficult for the central bank to raise its benchmark short-term interest rate while sticking to its 2% annual inflation target. One response would be to allow higher levels of inflation.

The research, due to be presented at a Brookings conferenceThursday, is likely to reignite debate about the central bank’s inflation strategy and could bring fresh calls for officials to raise the inflation target.

The papers come as Fed officials have been hinting they may let inflation exceed 2% temporarily. The Fed’s preferred inflation measure, the personal-consumption expenditures price index, has been moving up in recent months but has run below the target for more than four years.

The first paper—from the New York Fed’s Marco Del Negro, Domenico Giannone, Marc Giannoni and Andrea Tambalotti—backs the “savings glut” theory of low interest rates offered by former Fed Chairman Ben Bernanke.

The researchers focus on the real natural interest rate—the inflation-adjusted rate that balances saving and borrowing over time—and find it has dropped by up to 1.5 percentage points since the mid-1990s. (DRAW I = S DIAGRAM!)

PROJECTION MATERIAL FROM THE FOMC:

2012 - FOMC projections NEUTRAL LONG RUN FF = 4.1%

2016- FOMC projections NEUTRAL LONG RUN FF = 2.95%

About 1 percentage point of that decline, they argue, is due to the “convenience yield,” that is, world-wide demand for safe and liquid assets. As emerging markets have grown richer in recent decades, they have grown increasingly hungry for safe places to store their wealth, such as U.S. government debt. That has put downward pressure on the natural rate and on the yields of U.S. 10-year Treasury notes.

Other researchers have found other explanations for the drop in rates, such as a slowdown in the economy’s growth potential, the aging of the baby boomers (LIFE CYCLE THEORY OF CONSUMPTION 'SAYS' SAVE MORE AND SPEND LESS, ESPECIALLY IN A LOW INTEREST RATE ENVIRONMENTand a permanent drop in overall demand.

But the New York Fed researchers’ conclusions suggest that the driver for the current low-rate environment has less to do with changes in the U.S. economy than it does with an increase in global demand for safe assets. THE HOUSING BUBBLE WAS NOT GREENSPAN'S FAULT!

Unless that demand changes or unless new safe assets emerge to replace U.S. government bonds, those low rates are likely to stay, they write.

How should the Fed respond?

One way would be to allow higher inflation, according to Fed economists Michael T. Kiley and John M. Roberts.

With lower natural interest rates, the Fed will frequently bump against zero when it cuts its benchmark policy rate to boost the economy. That so-called “zero lower bound” limits the Fed’s ability to respond to crises, leading to longer, deeper recessions and weaker economic growth.

Mr. Kiley and Mr. Roberts suggest three ways for the Fed to avoid zero interest rates as much as possible.

First, the Fed could maintain its 2% inflation target but allow inflation to rise to 3% when the Fed’s interest rate is above zero to compensate for periods of lower inflation. That would give the economy some additional time to expand before the Fed raises rates and stifles growth. The authors, though, acknowledge that approach “only moderately improves” the economic picture.

Second, Fed officials could commit to holding nominal interest rates near zero until either inflation or economic growth overshoots their long-run levels. That would mean intentionally letting the economy overheat before taking any action to rein it in. The authors find this method “very effective.” DISCUSS HYSTERESIS

Finally, the Fed could simply raise its inflation target above 2%. That would give officials more room to raise nominal interest rates during expansions. THIS IS EFFECTIVELY GIVING THE FED MORE BULLETS - EXPLAIN IN REAL TERMS!. But letting prices rise too fast is a risky move, one that could potentially hurt households and businesses, they write. THERE ARE HAWKS THAT ARE STILL ALIVE, BUT NOT MANY!

While they don’t settle on a single answer, their suggestions are an indication that the current era of low interest rates has prompted rethinking of the Fed’s approach to inflation.

Fed officials themselves may be reaching the same conclusion. The statement following their March meeting included a mention of the central bank’s “symmetric” 2% inflation target, a pointed reminder that officials would tolerate slightly higher inflation for a while.

“Inflation is not always going to be at 2%,” Fed Chairwoman Janet Yellen said in her press conference following the meeting. “It’s alike all economic variables. It fluctuates. Sometimes it’s going to be below 2%. Sometimes it’s going to be above 2%.”

Write to David Harrison at