Markets Don’t Have Much Reason to Believe the Federal Reserve

The Federal Reserve wants to go full steam ahead in keeping our economic recovery strong. The US central bank announced a switch to “average inflation targeting,” and even more recently reiterated its commitment to dovish monetary policy. There’s just one problem: The Fed needs credibility to make this work, and right now it has little. Given its previous inability to hit its inflation target, we should be concerned the Fed will undershoot inflation, not overshoot it.

The Fed first adopted an inflation target in 2012. The goal was to give markets, still recovering from the financial crisis, a stable foundation for future growth. But the Fed persistently missed the mark: Inflation averaged only 1.5 percent over the last decade. As Fed Chairman Jerome Powell recently admitted, the Fed’s “persistent undershoot of inflation from our 2 percent longer-run objective is a cause for concern.”

Hence the switch to average inflation targeting. Under an average inflation target, the Fed would make up for lower-than-2-percent inflation today by allowing greater-than-2-percent inflation tomorrow. In other words, it’s no longer willing to let bygones be bygones. On paper, this is a smart move. If inflation averages 2 percent in the long run, then temporary deviations from the target won’t have a dramatic effect on consumption or investment. In contrast, under the old rule — which was really a 2 percent inflation ceiling, not a target — households and businesses had to spend time and effort trying to guess the Fed’s next move. This is bad for stability in the short run and bad for growth in the long run.

After Powell’s announcement confirming the average-inflation-targeting regime, commenters worried that the Fed was playing with fire. Market watchers lamented the prospect of “easy money as far as the eye can see…thus ensuring that a dollar every year is worth less.” Visions of stagflation — the combination of high unemployment and high inflation that gripped the US economy in the 1970s — danced in their heads. But this worry is misplaced. The proper concern is precisely the opposite: The Fed might not be able to create higher-than-2-percent inflation, even if it wants to.

This claim may seem absurd. Surely a central bank with a monopoly on high-powered money creation is never out of ammunition for boosting inflation! While this is true in the abstract, we have every reason to worry that the past decade’s accumulated muck of misguided monetary policy experiments will prevent the Fed from doing what’s necessary.

One such experiment was embracing a floor system for monetary policy. Previously, the Fed used open-market operations to achieve its macroeconomic goals. But now, there’s no longer a direct link between the Fed’s purchase or sale of assets and the stance of monetary policy. It uses the interest rate paid on excess reserves, instead of the size of its balance sheet, as its policy instrument. To dampen inflation, the Fed can raise the interest paid on excess reserves. To boost inflation, it can cut the interest paid on excess reserves. But now interest on excess reserves is almost zero. Unless the Fed wants to begin a dangerous experiment with negative rates on excess reserves, it should get back to a system where the size of its balance sheet matters, meaning it must act within the market.

Again, everything depends on credibility. Given the Fed’s persistent failure to hit its previous inflation target, markets are right to doubt the Fed’s resolve. Just look at the 5-year TIPS spread, a popular measure of the market’s inflation expectations. Also called the “breakeven inflation rate,” the TIPS spread looks at the difference in yields between 5-year Treasuries and 5-year inflation-indexed Treasuries, which represents the market’s belief about yearly inflation over the next half decade. The day of the Fed’s announcement, expected inflation was 1.65 percent. It rose to 1.69 percent, but then started a precipitous decline. Over the past week, it fluctuated between 1.53 percent and 1.57 percent.

The bottom line is that markets are telling the Fed, “We don’t believe you.” In truth, the Fed hasn’t done anything worth believing. They announced a policy change, but without an accompanying procedural change, it’s just cheap talk. If the Fed wanted to convince markets it was serious about its average inflation target, it would formally abandon the floor system, reestablishing the link between the volume of reserves in the banking system and overall macroeconomic variables, like inflation and unemployment. It would also retire its foolish experiments with credit allocation, such as direct loans to small- and medium-sized businesses, large corporations, and state and local governments. These policies blurred the line between fiscal and monetary policy, diminishing the Fed’s effectiveness.

But the Fed hasn’t done any of these things — or anything else that convinces markets it means business. That’s bad for the American economy. Until and unless the Fed makes a credible commitment to an average inflation target, the Fed will continue to let down the American public.