I don't get the Fed's supposed commitment problem

I've long been a proponent of the idea of inflation targeting by the Fed as a strategy for stimulating demand and reflating our moribund economy (for examples, see here, here and here)

Why isn't the Fed doing it already?

Today Tyler Cowen writes that the obstacles are mainly political.  My brief take on what Cowen is writing here is that the Fed's commitment to higher inflation needs to be credible for it to work, and if the Fed commits to higher inflation, some politicians will cry foul, which could not only compromise their commitment to sustained higher inflation, but ultimately threaten the Fed's authority and independence.

But politicians are always crying foul about the Fed's actions.  And if the Fed can't do what it should be doing, then its authority is already compromised.

Mark Thoma also emphasizes the commitment problem:
As for Tyler's (and others') call for monetary policy instead of fiscal policy, here's the problem. It relies upon changing expectations of future inflation (which changes the real interest rate). You have to get people to believe that the Fed will actually be willing to create inflation in the future when it comes time to do so. However, it's unlikely that it will be optimal for the Fed to cause inflation when the time comes. Because of that, the best policy is to promise that you'll create inflation, then renege on the promise when it comes time to follow through. Since people know that, and expect the Fed will not actually carry through, it's hard to get them to change their expectations now. All that credibility the Fed has built up and protected concerning their inflation fighting credentials works against them here.
I confess that I just don't get it.  I don't see why the Fed commiting to a 3 percent inflation target isn't credible.  As far as I can tell, a 3-percent long-run target is probably closer to optimal than the current 2-percent target anyway, even if the economy weren't depressed.  And since the Fed will want to have credibility the next time it makes a move, what is the incentive to deviate from their commitment post-reinflation?

Maybe the Fed fears powerful political forces.  But somehow Cowen's political argument strikes me as too nuanced. 

To the extent that politics are playing a role here, I expect the motives are more base than what Cowen describes.  On the one hand there is pure ideology.  Ideology of what I'm not sure, but some on the open market committee want to raise rates now because they fear too much inflation and too much easy credit, that our problems are structural, etc.  None of this makes sense to me, but I believe these guys believe what they are saying.  On the other hand there is the obvious fact that a bad economy is good for Republicans and not-so-good for Democrats.  Of course, if political power changes in November, maybe the political calculation for policy will change as well.  While I'm sure the folks on the open market committee try hard not to let their politics influence Fed policy, they are also human like the rest of us.

But I still don't get the commitment problem.

I actually think the Fed will ultimately target a higher inflation rate.  It's just going to take awhile.  Confirming Obama's three new nominees to the OMC will help to get us there.

Comments

  1. hoenig, fisher & lacker have all come out against QE at this time...

    ReplyDelete
  2. "I don't see why the Fed commiting to a 3 percent inflation target isn't credible."

    "Credible" means that the public believes that the Fed can actually implement its target. Suppose the Fed says "We're going to keep rates at zero until we reach 3%", and years go by without hitting 3% like in Japan. Then monetary policy will be seen as futile - not good for credibility.

    "But politicians are always crying foul about the Fed's actions. And if the Fed can't do what it should be doing, then its authority is already compromised."

    Fed bashing has gone mainstream. There's lots of pent-up anger from all sides. If the Republicans take back the House as predicted, there could be some serious legislation aimed at taking away the Fed's powers.

    ReplyDelete

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