MNI EXCLUSIVE: Fed Inflation Target Rethink Faces Hurdles

By Jean Yung

     WASHINGTON (MNI) - Alternative monetary policy approaches in which the

Federal Reserve commits to achieving above-2% inflation following periods of

underperformance may not be effective in practice unless the FOMC communicates

the strategies clearly and implements them consistently, current and former Fed

officials told MNI.

     The potential costs and benefits of proposed changes to the Fed's framework

need to be studied carefully over the coming months, they said, suggesting that

a new approach may not come together until well after a June conference devoted

to reviewing the policy strategies.

     "If the FOMC were to make a decision to change the inflation-targeting

approach -- and that's far from a foregone conclusion at this stage -- I think

the earliest would be toward the end of this year or some time in 2020," said

former Atlanta Fed chief Dennis Lockhart.

     Chair Jay Powell has initiated a major rethink of the Fed's approach after

inflation failed to heat up despite an economic boom late in an already-long

economic cycle. U.S. inflation has averaged below 2% not just since the Great

Recession but over the past 20 years, and officials fear persistently soft price

growth may undermine inflation expectations and erode the Fed's credibility to

achieve its mandate.

     "Some policymakers on the FOMC may harbor concerns that inflation

expectations readings could be interpreted as anchoring below the 2% target, and

they would not want to see that set of circumstances materialize," Lockhart

said.

     What's more, in a world with historically low neutral interest rates, the

Fed would likely not be able to reduce rates low enough to stimulate the economy

in a downturn, possibly resulting in even longer periods of below-target

inflation. The Fed's benchmark rate is currently in a 2.25% to 2.50% range;

historically, the Fed has dropped rates by 5 to 6 percentage points during

recessions.

     --CATCHUP STRATEGIES

     One alternative under consideration, price level targeting, would see the

Fed committing to keep the level of prices near a steadily-rising target path.

Another option calls for hitting an average inflation target over a period of

years. Both approaches would require the central bank to overshoot the 2% target

following periods of below-target inflation in an effort to lift expectations.

     An advantage of these so-called catchup strategies is that they would offer

business more certainty about where prices are headed in making longer-term

contractual arrangements, said Richmond Fed research director Kartik Athreya in

an interview last week.

     But communicating how the Fed would adjust policy according to its progress

towards such goals would not be easy, he said. These approaches "face

difficulties associated with making sure that people understand what would

actually be thresholds for the Fed to do various things."

     One complicating factor is the Fed's other mandate: maximum employment. It

would be difficult to pursue a single-minded inflation catch-up approach

requiring tighter policy after a period during which prices had exceeded target

levels if unemployment was high or rising.

     Additionally, if inflation rises considerably above goal, the FOMC could

also find it harder to explain its commitment to a 2% long-run target and may

even face a political backlash.

     "Maybe that commitment challenge is the greatest if you think of relatively

extreme scenarios. What would happen if inflation got more than just 50 or 75

bps away from your target?" said Richmond Fed adviser John Weinberg.

     --TARGET RANGE

     Boston Fed President Eric Rosengren recently championed a third

alternative: adopting an inflation range centering on 2%. It would be easier to

explain than price level targeting and would recognize that "there are limits on

policymakers' ability to be quite so precise in hitting an inflation target," he

said in a speech this month.

     If the FOMC were to move to emphasizing a range, "they'd encourage less

concern on the part of the public and less potential reaction in financial

markets to what amount to rather modest deviations from their 2% target,"

Lockhart said.

     "I don't think the objective is just to reach the inflation target for its

own sake. It's grounded in the belief that something very close to 2% is the

healthiest rate of inflation for the economy."

--MNI Washington Bureau; +1 202-371-2121; email: jean.yung@marketnews.com

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