Considering Alternative Monetary Policy Frameworks: an Inflation Range With an Adjustable Inflation Target
Boston Fed President Eric Rosengren today suggested that the Federal Reserve’s monetary policy framework has an opportunity to adapt to the recent experience with prolonged low interest rates.
Rosengren said low inflation has enabled the Federal Reserve to pursue a very gradual exit from the “extraordinary” monetary policy accommodation undertaken to address the financial crisis, Great Recession, and slow recovery – adding that he does not view the “somewhat lower than expected” recent inflation rate as particularly troublesome for near-term monetary policy.
But “I do see low and fixed inflation targets as a potential problem – particularly if we continue to experience low productivity growth, a low equilibrium interest rate, and the near-certainty of a slowly growing and aging workforce,” Rosengren said.
In such an environment and with a two percent inflation goal, interest rates are likely to be low, on average. When a recession eventually does occur, Rosengren said, policymakers would likely start with a low policy rate leaving little room to lower rates to offset the effects of the recession.
In addition to making it difficult to conduct monetary policy, low interest rate environments can potentially undermine financial stability, he said, as households and firms “reach for yield” in the face of low interest rates, almost always taking on additional risk as a consequence.
Fundamental changes such as lower growth in productivity and in population have made it much more likely that future recessions could also result in periods of prolonged very low interest rates and a need to conduct monetary policy with nontraditional methods.
“If we seek to avoid a prolonged low interest rate environment in the future, then policymakers should start studying and discussing alternative frameworks to make this outcome less likely.”
Suggesting that the “optimal” inflation rate is not likely to remain constant over time, Rosengren offered the alternative of an inflation range with an adjustable inflation target – a range of inflation rates acceptable to policymakers across many economic circumstances, and a medium-term goal within that range policymakers would set depending on the current circumstance.
Still, Rosengren acknowledged that such flexibility would generate more uncertainty about inflation in the medium to long run. However, he said as long as the inflation rate were in a relatively narrow band, such as 1.5 to 3.0 percent, the range would not be a dramatic change from actual experience and would therefore be less likely to impact inflation expectations.
Turning to forecasts, Rosengren said recent forecast errors of inflation and unemployment have not been particularly large, and do not pose much challenge to continuing on the current path of gradual increases in the federal funds rate.
“Perhaps the bigger risk for short-run policy is the fact that the unemployment rate continues to fall further below sustainable levels, and will likely continue to do so going forward, risking the sustainability of the recovery.”
Rosengren was speaking at the Money, Models, & Digital Innovation Conference hosted by the Global Interdependence Center.