Monday, December 14, 2015

The Fed Gets What It Wants: A 1%-2% Inflation Target Corridor

So it is finally time for lift off. The Fed is poised to raise short-term interest rates over the next few days after seven long years of ZIRP. Exciting as this development may be, it is important to keep in mind that the guiding principle behind the Fed's decisions during this time has not suddenly changed. This principle says that no matter what happens--whether it be ZIRP, QE, forward guidance, the changing winds of fiscal policy, or the normalization of monetary policy--the Fed must always act in a manner to keep core PCE inflation within a 1-2 percent inflation corridor. 

Yes, even though the Fed has an official 2 percent inflation target revealed preferences indicate the real force shaping Fed policy has been a 1-2 percent inflation target corridor over the past seven years. Once you understand this point all other Fed mysteries begin to clear up. For example, why did the Fed sterilize its lending to banks between December 2007 and October 2008? Or, why did it introduce IOR just as the markets were imploding or make the asset purchases under QE temporary? The answer is that it did not want rapid growth in nominal spending--even though it was sorely needed--for fear of pushing inflation too high.  The Fed, in other words, was willing to sacrifice the economy at the altar of the inflation target corridor. This framework is likely to continue going forward.

But don't take my word for it. Let's look to the data and let the FOMC's revealed preferences speak for themselves. 

Consider first the central tendency consensus forecasts of core PCE inflation by FOMC members.  The figures below show these forecasts for the current year, one-year ahead, and two-years ahead horizons. A clear pattern emerges from these figures as you expand the forecast horizon: 2 percent becomes a upper bound. FOMC officials, therefore, have been consistently looking at an upper bound of 2 percent for core PCE inflation. If we add to this fact that the FOMC has meaningful influence on inflation several years out, then these revealed preference are saying Fed officials actually want and expect to get an inflation upper bound of 2 percent. This inflation corridor is a choice.


Now consider the actual performance of core PCE inflation since the crisis started. This is where the 1 percent lower bound on the corridor becomes evident. The Fed seems ready to pull the monetary trigger if core inflation drifts too close to this lower bound. Currently, core inflation has stabilized around 1.3 percent but should it start falling again I would not be surprised to see the Fed getting trigger happy once again.

These revealed preferences of the Fed have begun to affect the public's long-term inflation expectations.The figure below shows the annual average inflation forecast over the next 10 years from the Survey of Professional Forecasters. I would not call these forecasts unanchored, but they are gradually drifting down. In the past we worried about expectations becoming unanchored as inflation expectations drifted upward. Now it seems they are drifting in the other direction, though presumably anchored by a lower bound.

The low inflation environment of the past few years seems entirely in line with the revealed preferences of FOMC officials. There is nothing mysterious about it. Fed officials are getting what they want. Unfortunately, aiming for a inflation corridor of 1-2 percent does guarantee macroeconomic stability. This inflation target range could be either be too tight or too easy depending on the state of the economy. It would be far better for the Fed to simply stabilize the growth path of aggregate spending. Until then, expect the Fed's decisions to be guided by the inflation target corridor. 

P.S. See Russ Robert's interview of George Selgin on EconTalk for an interesting discussion where some of the Fed's mysterious actions over the past seven years are discussed.

Update: Janet Yellen, made this point in the press conference following the December 2014 FOMC meeting (my bold):
But it’s important to point out that the Committee is not anticipating an overshoot of its 2 percent inflation objective (p.13).


  1. The Fed continues to erode it's credibility.

    The 5-year Treasury-TIPS breakeven rate is currently ~ 1.2%. The 5-5 forward breakeven rate is 1.75% and falling. At the same time, futures market prices indicate better than an 80% chance that the Fed will tighten on Wednesday. So the market believes the Fed will take action this week to keep medium run and long run inflation within the 1% to 2% corridor.

    And yet, after the October FOMC meeting, Janet Yellen emphasized several times that the Fed has a 2 percent inflation target, not a 2 percent ceiling. Here is a quote from the press conference:

    "So let me be clear—2 percent is our objective. We want to see inflation go back to 2 percent; 2 percent is not a ceiling on inflation. So we’re not trying to push the inflation rate above 2. It’s always our objective to get back to 2, but 2 percent is not a ceiling. And if it were a ceiling, you would have to be conducting a policy that, on average, would hold the inflation rate below 2 percent. That is not our policy. We want to see the inflation rate get back to 2 percent as rapidly as we can."

    Really? The market certainly doesn't believe it.

    1. Sorry, but inflating the oil bubble in 2010 was stupid. Core CPI is 2%. Deal with it. The Fed has figured out lowering oil prices is the key to stability. They should have known that in 2010 and never did any QE.

    2. Anonymous, based on your logic the Fed must have crashed the oil marketing 2008-2009! Seriously, do you really think the Fed controls oil prices?

  2. The path of aggregate spending is already stable. Get your head out of backside and look at the real path. The 00's were a BRIC driven blip. It is back to its normal path.

    Inflation ex-commodities is indeed rising. The market is a mess right now. They got so used to a way to trade, they have forgotten to look at under the hood and see what is really going on. Look at November retail sales. When you look at ex-gas, they probably rose .3-4%. But add in the deflator they rise to .6-7% because the oil plunge has made everything cheaper to sell at lower prices.

    Once oil goes back to its inflation adjusted price compared to 1999, those price drops will end.

    1. Sorry anonymous, but we have only partly made our way back. Look at the share of household liquid assets which drives spending. It is still adjusting. Or look at these estimates of nominal spending relative to where they should be or the sustained decline of yields on safe assets. All of these point to a world where spending has been depressed.

    2. Sorry right back. Your saying nothing. Nominal spending in the 00's is a blip, not a target. Your a mess.

    3. Wow, ad-hominen attacks versus engaging the argument. Very convincing anonymous.

  3. Excellent blogging.

    In addition, both Yellen and Fischer have made comments about the economy "getting back to the 2% target," so tightening is okay. I forget the exact language used, but both have used the 2% figure in language as if the target were a ceiling.

    Never has a Fischer or a Yellen said, "You know, 2% is an average target. If we run at 3% inflation for a couple of years, that will only balance our last several years. So we have room on the upside for a while."

    Of course, this whole discussions assumes that an average 2% IT is even the right target. What if it is too low? What if we obtain greater long-term real growth with a 3% IT?

    In the 1982 to 2007 period, the US ran a little north of 3% real growth, and just under 3% inflation, averages for the whole period. That's in the real world, structural impediments and all, with real workers, businesses, tax codes, wars, droughts and all the rest. Over 25 years, through business cycles.

    I do not see the US topping the 1982-2007 period with a 2% IT-ceiling.

    1. "I forget the exact language used, but both have used the 2% figure in language as if the target were a ceiling."

      Then they're sending mixed messages because to me the meaning of this statement is crystal clear:

      "So let me be clear—2 percent is our objective. We want to see inflation go back to 2 percent; 2 percent is not a ceiling on inflation."

      That is Yellen from October this year.

  4. As I try to grasp this economic debate, not being an economist, I am struck by the fact that the Fed is in the business of protecting banks, not fixing the economy. The Fed won't have your backs, Market Monetarists. The Fed will let you down even if it created a bubble again in housing. And really, don't people really want a bubble in real production instead of in housing? And even then, the Fed won't have your backs if there is a bust. And David, the Fed tightening started way before IOR. It started way back in late 2007 when it ignored the LIBOR explosion. Banks were headed towards a disaster and the Fed did nothing back then! So for a year they tightened or simply failed to loosen. I wrote about this tightening here: I am not an economist, but a blind man can see with his cane that the Fed did nothing, as the chart in the article points out. I am curious as to your view. So, the Fed tightened by doing nothing. And, IOR was just more tightening, and some say it was the result of the bubble bursting and you guys say it was the cause of a bigger burst. I think you are right, but the Fed will never have the guts to prove it, in a repeating scenario.