January FOMC Meeting – Extended discussion of inflation forecasting

Following the staff presentations, participants discussed how the inflation frameworks reviewed in the briefings informed their views on inflation and monetary policy.

Almost all participants who commented agreed that a Phillips curve-type of inflation framework remained useful as one of their tools for understanding inflation dynamics and informing their decisions on monetary policy.

Unfortunately, they overlook the fact that Phillips Curves do not depict a structural relation. The Phillips Curve is not invariant to monetary policy behavior. In short, it is the Fed that creates the correlations between inflation & unemployment.

The Lesson: Phillips Curve analysis is not a reliable guide to formulation of monetary policy!

The above view is implicit in the discussion that follows:

Policymakers pointed to a number of possible reasons for the difficulty in estimating the link between resource utilization and inflation in recent years.

These reasons included an extended period of low and stable inflation in the United States and other advanced economies during which the effects of resource utilization on inflation became harder to identify.

The shortcomings of commonly used measures of resource gaps, the effects of transitory changes in relative prices, and structural factors that had made business pricing more competitive or prices more flexible over time.

The presentation also suggests that future discussions on alternative monetary policy frameworks will take place

… Several participants indicated that they viewed the available evidence as suggesting that longer-run inflation expectations remained well anchored; one cited recent research finding that inflation expectations had become better anchored following the Committee’s adoption of a numerical inflation target.

However, a few saw low levels of inflation over recent years as reflecting, in part, slippage in longer-run inflation expectations below the Committee’s 2 percent objective. In that regard, a number of participants noted the importance of continuing to emphasize that the Committee’s 2 percent inflation objective is symmetric.

They´ve been doing this for some years now, without success!

A couple of participants suggested that the Committee might consider expressing its objective as a range rather than a point estimate.

As the chart suggests, for the past several years, the misses in this case would have been much less systematic.

A few other participants suggested that the FOMC could begin to examine whether adopting a monetary policy framework in which the Committee would strive to make up for past deviations of inflation from target might address the challenge of achieving and maintaining inflation expectations consistent with the Committee’s inflation objective, particularly in an environment in which the neutral rate of interest appeared likely to remain low.

That would be a Price Level Target (PLT) framework. It is certainly an improvement over IT. Unfortunately, it shares with IT the problem of how to deal with supply shocks (which was behind the Fed´s grave error in 2007-08).

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