Low inflation ahead, but Fed must detail exit strategy, SOMC says

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The Federal Reserve aggressively reacted to the coronavirus pandemic, and the early stages of recovery will feature low inflation, or deflation, but the Fed must be as aggressive once the pandemic ends, according to members of the Shadow Open Market Committee.

Observers said the Fed learned from the past, choosing to act quickly and aggressively to the COVID-19 issues. Similarly, Rutgers University Professor Michael Bordo said, “The lesson for the Fed is once the pandemic emergency comes to an end, it must reduce its expansionary policies to avoid a run up in inflation and to allay inflationary expectations it should clearly spell out its exit strategy.”

Although the Fed has rules out negative interest rates, except as a last resort, Bordo said, “negative rates might be more potent” than some of the Fed’s other tools.

In the early stages of recovery, “We can expect soft prices, low inflation and maybe even mild deflation,” according to Berenberg Capital Markets Chief Economist for the U.S. Americas and Asia Mickey Levy.

After the Great Recession inflation didn’t rise despite near-zero rates and quantitative easing because “they failed to stimulate economic growth,” he said.

Mickey Levy
Berenberg Capital Markets Chief Economist for the U.S. Americas and Asia Mickey Levy said the Fed is in a weak position now “in part because they never unwound their emergency measures” after the last crisis.

Levy said, “The markets rely so much and expect so much from the Fed” that it’s become an “unhealthy relationship.” And while the Fed realizes “it’s in this trap,” Levy said, “it doesn’t know what steps to take to get out of it.”

Responding to a question, Levy said the Fed is in a weak position now “in part because they never unwound their emergency measures” after the last crisis “and just let their balance sheet go up and up.”

Also, the Fed recently suggested its quantitative easing “didn’t have the impact on aggregate demand that they earlier said it did.” So it is in a weak spot because it has a large balance sheet, rates are near zero, and “what policy should they use if QE didn’t work and they’re reticent to use negative rates?”

Despite this, Athanasios Orphanides, professor at MIT, noted, while the “Fed is not in an extremely good position,” it is in a better position than other central banks.

What he considers crucial “for the medium- and long-term effectiveness of monetary policy is for the central bank to maintain credibility that it will deliver over the medium- and long-term price stability as it defines it.”

The Fed should communicate in June how it would handle “different eventualities, like inflation and deflation, so we can be assured they will deliver 2% inflation in the long run.”

The answer for the Fed may be using rules based monetary policymaking, according to Peter Ireland, an economics professor at Boston College. “Experience has shown that even under the best of circumstances it is extremely difficult for a central bank to operate under pure discretion … in an attempt to successfully fine-tune the economy.”

No tool the Fed has will guarantee inflation will be near 2% in the next 12 months “because there are too many other things going on in the economy,” he added. And while it doesn’t matter if there are small misses on inflation, the concern is “about extreme outcomes on either side.”

By using rules, the Fed “drastically minimizes the chances of either.”

It could “announce specific policy rules for managing the fed funds rate and determining the magnitude of QE bond buying programs and adhere to them,” Ireland said. “Those rules would say monetary policy needs to remain accommodative so long as the short-run deflationary pressures continue to hold sway.”

Similarly, the rule would dictate “monetary policy accommodation would have to be removed and even replaced by monetary restraint if significant inflationary pressures begin to build and persist,” he said.

The webcast was hosted by the Manhattan Institute.

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