The new policy rule nominally retains the Fed’s 2012 inflation target of 2 percent. However, it changes how the Fed will react both to shortfalls of inflation from its target level, as well as to deviations of employment from its “maximum level.” It turns out that both these changes will likely bias inflation to exceed the Fed’s professed target.
Inflation Shortfall Offsets
Under a simple Taylor Rule, the Fed attempts to control near-term inflation by manipulating short-term interest rates, with no reference to past inflation except as it enters a proxy for the public’s inflationary expectations. It usually misses its inflation target one way or the other, either because it has mis-estimated the neutral real interest rate r*, mis-judged the public’s inflationary expectations, or just because of random micro-shocks to the economy. All of this is to say that even medium-run average inflation will ordinarily be randomly above or below its 2 percent target.
The Fed’s new plan is to try to reduce these long-run misses by attempting to offset past inflation shortfalls with deliberate excess future inflation. For example, if inflation has been averaging only 1 percent for the past few years, it might temporarily target 3 percent inflation in order to bring long-run average inflation, and therefore inflationary expectations, more quickly in line with its 2 percent long-run target.
Neither the FOMC Statement nor Powell’s speech mentions whether these corrections will be symmetrical: If inflation has been running 3 percent or even 6 percent for a few years, will the Fed then temporarily target 1 percent inflation or even 2 percent deflation in order to bring the long-run average closer to its long-run target? One suspects that the Fed will offset the shortfalls but not the overages, with the result that under the new rule, inflation will in fact systematically average more than the announced 2 percent target over the long-run.
The Wicksell Rule
Back in 1909, the Swedish economist Knut Wicksell proposed a rule that has attracted considerable academic interest of late and is somewhat similar to the Fed’s new policy. Like Taylor, Wicksell would manipulate inflation with tight or easy money as evidenced by the stance of short-term interest rates. However, Wicksell’s proposal was to target the price level (P) itself rather than the inflation rate. Wicksell had in mind a constant price target with zero inflation, but his rule could apply equally well to a price level trajectory that increased at a constant rate, say 2 percent per year, from a selected constant base date, say January 2000. If the actual price level (P) was below its target trajectory, his rule would have the central bank temporarily target more than 2 percent inflation until P was back on track. Symmetrically, if actual P was above the target trajectory, the central bank would temporarily target less than 2 percent until P was back on track. If, as Wicksell had in mind, the target trajectory was a constant, the central bank would have to temporarily target deflation until P was back on target.
A rigorous Wicksell Rule (with or without uptrend) has the theoretical advantage that under it, the price level will be what econometricians call trend stationary, in that it will tend to follow the target trajectory closely, with finite long-run variance, whereas under the Taylor rule, the accumulated policy errors make the price level non-stationary, so that the future price level will eventually drift arbitrarily far from its starting point plus target inflation.
Under the Taylor Rule, any mis-estimation of r* on the Fed’s part will cause inflation to average above or below the Fed’s target, in addition to the accumulated policy errors. Under the Wicksell rule, on the other hand, mis-estimation of r* will cause the price level to lie on average above or below the target trajectory, but long-run average inflation will still equal the target implied by the trajectory, with zero variance, and the long-run price level forecast error will have finite variance.
Unlike the Wicksell Rule, however, the Fed’s new rule is not based on a fixed reference date in the past, but rather allows it to average past inflation over an unspecified period, to be determined in an ad hoc manner. Therefore, even if it were applied symmetrically, it would not achieve “trend stationarity.” Furthermore, the Fed likely will treat inflation overages differently than inflation shortfalls, so the rule is not even symmetrical. It is therefore at best only a “Semi-Wicksell Rule.”
Employment Policy
In addition to a proxy for the public’s experience-based inflation forecast, the Taylor Rule[1] ordinarily contains a term reflecting the unemployment gap (U‑gap), the deviation between current unemployment (U) and the estimated “Natural Unemployment Rate” that will result if inflation is fully in line with expectations. Typically, positive and negative values of U‑gap enter symmetrically, so that the Fed will be stimulative if U‑gap is positive, as in a recession, and equally restrictive if U‑gap is equally negative. Since unexpected inflation is zero on average, U‑gap will also be zero on average, abstracting from any non-linearity of the Phillips curve.
In its new monetary policy statement, the FOMC states that “the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level” (emphasis added). In his speech, Chairman Powell notes that this is in contrast to the 2012 Statement, which instead referred to deviations from its maximum level. Neither the Statement nor Powell’s speech indicates how “maximum employment” is to be measured—it can’t seriously mean 100% labor force participation with zero unemployment.
Powell does, however, provide a chart of “Real-Time Projections of Longer-Run Employment Rate,” with separate lines for the FOMC, Blue Chip, and CBO projections. His text explains that these are estimates of the natural rate of unemployment, in otherwise the minimum sustainable level of U without unexpected inflation. If “shortfalls of employment from its maximum level” are interpreted to mean “unemployment rates in excess of the natural rate of unemployment,” then the Fed is proposing to react expansively to positive values of U‑gap, but not at all to negative values. But if it does this, it will be stimulative on average, relative to what is required to meet its purported inflation target of 2 percent. The Fed may as well admit it is increasing its inflation target to 3 or 4 percent and then responding symmetrically to U‑gap.
The term “maximum employment” in the Statement was evidently dictated by the Fed’s mandate from Congress to promote “maximum employment” as well as “stable prices.” It is now generally recognized, by just about everybody but Congress, that using monetary policy to literally maximize employment would imply runaway inflation, and therefore be completely at odds with price stability. The Fed is already bending its “price stability” mandate to mean “just a little inflation.” In order to appear to be in compliance with its “maximum employment” mandate, the Fed is apparently likewise twisting it to mean “the maximum employment that is consistent with stable inflation.“
*********
[1] In John Taylor’s original 1993 formulation of what has come to be called the “Taylor Rule,” he in fact used what he called “y‑gap,” the gap between real income y and its trend level, with a positive coefficient, rather than U‑gap. However, it is now generally believed that real income is not trend-stationary, rendering y‑gap meaningless, so that most practitioners substitute an estimate of U‑gap, with a negative coefficient.
