Evans doctrine gains traction at Fed
Once seen as an extreme, even imprudent notion in the corridors of respectable central banking, the idea that a little bit of inflation is needed to let some of the air out of a decades-long debt bubble is gaining ground in establishment economics. Even the U.S. Federal Reserve, a central bank that prides itself in offering a high degree of steady predictability on inflation, is now actively pondering taking more drastic steps, such as linking the path of interest rates to the direction of unemployment or inflation.
One particularly striking passage in minutes to the Fed’s August meeting signaled such an approach was much closer to becoming policy than investors and economists had believed:
In choosing to phrase the outlook for policy in terms of a time horizon, members also considered conditioning the outlook for the level of the federal funds rate on explicit numerical values for the unemployment rate or the inflation rate. Some members argued that doing so would establish greater clarity regarding the Committee’s intentions and its likely reaction to future economic developments, while others raised questions about how an appropriate numerical value might be chosen. No such references were included in the statement for this meeting.
Reuters flagged the theme on Sept. 2 (Fed could get specific on goals if recession hits), just as Chicago Fed President Charles Evans began campaigning for such an approach, which depending on its form might be referred to as price-level targeting. Under such a regime, the Fed would allow inflation to surpass its 2 percent goal for a period, letting it rise to, say, 3 percent, in an effort to stimulate investment and economic activity. Evans argued before the European Economics and Financial Centre in London last week:
We need to take strong action now. Given how truly badly we are doing in meeting our employment mandate, I argue that the Fed should seriously consider actions that would add very significant amounts of policy accommodation. If 5 percent inflation would have our hair on fire, so should 9 percent unemployment. Such further policy accommodation does increase the risk that inflation could rise temporarily above our long-term goal of 2%. I do not think that a temporary period of inflation above 2% is something to regard with horror.
Is Evans alone? JP Morgan’s resident Fed watcher Michael Feroli thinks not:
Chicago Fed President Charles Evans has been one of the most dovish members of the FOMC over the past year or two. For that reason, it is tempting to dismiss his very dovish comments today as representative of the fringe of the committee, and no more informative about the center than speeches by equally hawkish members of the committee. Certainly there is an element of truth to this. For example, his argument that 9 percent unemployment is as bad for the Fed as 5 percent inflation may be adeptly argued, but its not clear the center of the committee would share this view.
On the other hand, his advocacy of a ‘trigger policy’ for Fed communications should not be seen as completely alien to centrist opinions on the committee. As a particular example of this trigger policy Evans offers that the Fed could commit to keeping rates where they are until the unemployment rate falls to 7.5 percent or 7.0 percent, as long as medium-term inflation stayed below 3%. Note that this is not unemployment rate targeting — as his unemployment rate trigger is well above where the committee sees the natural unemployment rate — rather it is establishing numerical triggers that have to be breached before rates rise. Also note that he is not advocating raising the inflation target from 2 percent to 3 percent, but rather stating that if desired inflation is 2 percent — on average — then 3 percent inflation is sufficiently far from that target to consider abandoning the low rate policy.
This doesn’t mean inflation hawks won’t put up a fight. Former Fed Vice Chair Donald Kohn, hardly a hawk himself, told the National Association for Business Economics conference in Dallas this week that letting inflation rise above 2 percent would “likely to do more harm than good.” He continued:
I really would fear the side effect from unanchoring inflation expectations. It took about 30 years to get inflation expectations well anchored. Unanchoring them would be a very adverse side effect.
Still, the dovish camp, which includes Ben Bernanke, the Fed’s influential chairman, and Janet Yellen, his No. 2, definitely have the quorum they need to ease as aggressively as they see fit.