The Fed’s latest thinking
Interview of Chicago Fed’s president Charles Evans, one of the vocal doves on the Fed’s Open Market Committee (or FOMC). Evans advocates the Fed should target on employment growth, and consider raising inflation target to 3%, instead of 2%.
He favors the Fed clearly states its future course of actions and offers clear forward guidance contingent on economic outlook. He cited a piece by Mike Woodford on FT, who made the following forceful argument:
…Mr Bernanke can and should use his speech today to explain how his policy intentions are conditional upon future developments.
A clarification could help the economy in two ways. First, he could signal that a temporary increase in inflation will be allowed, before policy tightening is warranted. This would stimulate spending by lowering real interest rates. Second, specifying the size of any permanent price-level increase would avoid an increase in uncertainty about the long-run price level. This in turn would ward off an increase in inflation risk premiums that might otherwise counteract the desirable effect of the increase in near-term inflation expectations.
Uncertainty about the economic outlook is likely now the most important obstacle to a more robust recovery. The problem is not just uncertainty about Fed policy, but the fact that the Fed has become harder to “read” does not help. Better Fed communication, long on the agenda, would be particularly helpful at this juncture. Jackson Hole provides Mr Bernanke with the ideal opportunity.
My problem with Woodford’s recommendation is, how can the Fed convince people that the raise of inflation target is going to be temporary? What if employment situation won’t get any better after raising inflation target to 3%? Will 4% then be tolerable? Will this generate a positive spiral of inflation (expectations)??