As the Federal Open Market Committee prepares to meet next week, much has been said about its 2% inflation target and some have suggested that alternative frameworks need to be discussed.

Paul Mortimer-Lee
Paul Mortimer-Lee

“One of the problems is that 2% inflation targets are too low,” according to Paul Mortimer-Lee, chief market economist and head of U.S. economics at BNP Paribas. In a downturn, traditionally the Fed has needed at least 500 basis points of room to cut, and with the fed funds rate target at a 1.25% to 1.50% range, and even with three rate hikes expected in 2018, by the end of the year the Fed would have less than half the ammunition needed.

In the minutes from December FOMC meeting, a growing number of participants suggested investigating alternative frameworks for monetary policy “could be useful,” Mortimer-Lee noted in a research paper. “We perceive both this language shift and increase in interested participants as a possible signal that the Fed could produce such a study this year.”

Should the Fed follow through it “would be perceived as a dovish development, given that alternative policy frameworks are likely to focus on price-level or nominal GDP targeting, which would imply that the Fed could be more accommodative and allow some inflation catch-up to make up for past years of undershoots.”

While inflation targeting works when inflation is too high, a different approach is needed now, he wrote. “[C]entral banks are fighting the last war,” and inflation targeting “has created financial instability.”

“The answer to the dual problem of having too low inflation at the moment and not enough room to cut real rates in a recession is obviously to raise inflation expectations and, therefore, the inflation target,” according to Mortimer-Lee.

The solution, he suggests, “is to give up the 2% target permanently. If an explicit raise is out of the question and a temporary shift could be ineffective, then an alternative such as a nominal GDP target starts to have much more appeal. We also agree with the BIS that financial stability needs to be given far more weight.”

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