Part III: The Consequences of Trying Too Hard:
To be clear, The Fed is not reconsidering its ultimate goal of achieving long-term price stability but only whether it should revise the means of achieving that end. A new inflation targeting regime should meet some basic pre-conditions including clarity of purpose, transparency of execution, effectiveness in achieving the goal of price stability and a convincing case that trying harder will not cause collateral damage. The rationale for considering alternative targets for monetary policy, of course, is the current framework has not managed to reach its 2% target on a consistent basis, but it is not clear that some other target would have done any better over the past decade or so. In my judgement, structural forces - including the rise in monopoly power, technological innovations that enabled both China’s rapid industrialisation and global distribution, and widening inequality - have overwhelmed the traditional sources of inflation that arise when labour and product markets become overstretched.
In that context, the Fed needs to make clear that it is assessing its inflation target because the nature of inflation itself has changed. Simply trying something new for its own sake will not impress financial markets. Similarly, any new framework should be sufficiently transparent so as not to cause confusion. Indeed, transparency was the key rationale for making the Fed’s targets explicit in the early 2000s after two decades of internal use.
By far the greatest concern, however, is that no alternative monetary regime is likely to be more effective than the current one in thwarting the forces of deflation any time soon. The harsh reality is that low unemployment has not translated into higher wages and inflation. Employers commonly complain that they cannot find qualified workers to fill vacancies, yet they do not raise the pay scales for job openings to attract a broader range of potential candidates. Observers often refer to this conundrum as the demise of the so-called ‘Phillips Curve’, namely the inverse relationship between unemployment and wage inflation. By my estimate, inflation is roughly half as responsive to tight labour and product markets as it was 20 years ago. In short, monetary stimulus does not generate nearly as much ‘punch’ to economic growth or inflation as it once did. A regime change is not likely to change that harsh reality, no matter how hard the Fed tries to do so.