Five year TIPS spreads are at 1.5%. Because the Fed targets PCE inflation, and because 2.0% PCE inflation is roughly equivalent to 2.4% CPI inflation, the Fed’s target is roughly a TIPS spread of 2.4%. So 2014-19 inflation expectations are 0.9% below target. Here’s Ryan Avent:
American markets are once again hunkering down for a bout of disinflation. Expectations for inflation over the next five years have fallen half a percentage point since July, to around 1.5%: a level at which the Fed has previously moved to begin new asset purchases.
It’s important to recall that the Fed has a dual mandate, so this fact doesn’t necessarily imply that money is too tight. Later we’ll see that it is too tight, but let’s first consider the counterargument.
The Fed’s dual mandate covers both inflation and employment. Thus the Fed should push inflation above their target when unemployment is high, and they should push inflation below target when the unemployment rate is low. It seem likely that unemployment will be below average over the next five years, if only because it’s been above average for the previous six. So it’s possible that money is not too tight. Possible, but extremely unlikely. Here’s Ryan again:
THE monetary economics of a world in which interest rates are close to zero are not especially mysterious. Stimulating the economy at that point requires central banks to raise expected inflation. Disinflation, by contrast, results in passive tightening, since the central bank can’t lower its policy rate and since the real interest rate is the policy rate less expected inflation. In this world, the downside risks are much larger than those to the upside. There is infinite room to raise interest rates if inflation runs uncomfortably high (one might even welcome that opportunity to push rates up as that would reduce the probability that rates would fall to zero again in future). But there is no room to reduce interest rates if inflation is running to low. That, in turn, forces central banks to use unconventional policy or run psychological operations to try to boost expectations. Central banks are not very good at those sorts of things.
Suppose that the Fed runs inflation at 1.5% over the next 5 years, and then we hit another recession. In theory, the Fed should then push inflation much higher. But as Ryan’s comment suggests, exactly the opposite is likely to happen. The Fed will let inflation fall even below 1.5% in the next recession, and we’ll be in exactly the same position we are today.
This means that the real problem is not that money is too tight today (although it is) but rather that the entire monetary regime is flawed. Level targeting of prices would be better (and is the no-brainer solution to the euro-crisis, given their fixation with inflation targeting. But the ECB is not a no-brain, it’s a negative brain.) Another solution is NGDP targeting. Even better would be NGDP level targeting. These are ways of moving away from the Fed’s current procyclical monetary policy.
Ryan’s comment also points to the danger of passive tightening. Many people still have trouble with the notion that monetary policy could be tightening even as central banks “do nothing.” But clearly they can (and this isn’t just a MM view, it’s also a New Keynesian view, and an old monetarist view.)
TravisV sent me an article indicating that the Fed is beginning to understand the situation:
St. Louis Fed President James Bullard told Bloomberg TV that the Fed should consider delaying the end of quantitative easing in response to tumbling inflation expectations.
His concern was tumbling inflation expectations. . . .
Bullard was basically echoing the concerns of San Francisco Fed President John Williams, who suggested the Fed may have to increase its asset purchase program.
I don’t always agree with Bullard, but to his credit his views are always data driven. He’s an important swing vote at the Fed, as he’s one of the moderates.
PS. Once again, we’d have a much better idea of whether money is too tight if we had a NGDP futures market. But the Fed isn’t willing to spend $2 million dollars to set up a subsidized prediction market that would provide useful forecasts, even as trillions of dollars of wealth (and lots of potential jobs) are being wiped out each week. And the economics profession is equally apathetic. Over at Econlog I have a related post.