Federal Reserve Policy Outlook: Time for a Strategy Reboot?

13 Jun 2016

Summary

  • Downside risks to global growth, the fragility of inflation expectations and the proximity of the zero interest rate lower bound all point to challenges ahead for the Federal Open Market Committee (FOMC) in reaching and sustaining inflation at the two percent objective.
  • Indeed, there are already signs that the long period of undershooting the inflation objective is damping inflation expectations.
  • Given the aforementioned risks, the Committee should consider a strategy shift, delaying further rate increases until inflation hits two percent and looks set to remain at or above that level.

Introduction

The FOMC has embarked on a strategy of gradually tightening policy to bring inflation slowly back to the two percent objective, despite a number of factors that present challenges to this approach. These include downside risks to global growth, declining inflation expectations and limited policy options should the outlook deteriorate. Faced with these headwinds to achieving the inflation objective, this note considers an alternative strategy under which the Committee would forestall additional rate increases until inflation hits two percent. The strategy would also make clear a tolerance for above-objective inflation in the years ahead, with the goal of more rapidly returning average inflation to two percent over the medium term.

A Sensible Strategy for Policy Tightening, in Theory….

Well ahead of raising the target range for the federal funds rate last December, the FOMC went out of its way to communicate the rationale for beginning policy normalization before inflation reached the two percent objective. Two features of the strategy, the level of the real equilibrium policy rate and avoiding significant inflation overshoots, are worth reviewing since they may explain some of the challenges that the Committee has faced in achieving sufficiently strong growth to boost inflation. On the first of these strategy elements, the Committee has long articulated that the real policy rate consistent with full employment and the two percent inflation objective, also known as cyclical r*, was expected to rise gradually as headwinds from the financial crisis faded. As a result, the Committee would need to raise the target range for the federal funds rate to at least keep track with the estimated increase in r*; absent such an adjustment in the actual policy rate, a rise in cyclical r* would lead to a looser stance of policy. And if inflation was returning to objective as the labor market strengthened, the real policy rate would need to rise by even more than the estimated increase in r* in order to tighten policy over time.

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