Sunday, April 1, 2018

Inflation Benefits the Borrower

"Embracing higher inflation, however, could cause political problems for the Fed."

from https://www.nytimes.com/2018/02/23/us/politics/federal-reserve-interest-rate-increase.html

As Economy Grows, Federal Reserve Frets Next Downturn

Photo
Jerome H. Powell, the chairman of the Federal Reserve, which is confronting the question of how quickly to raise interest rates. CreditJoshua Roberts/Reuters
The Federal Reserve on Friday described recent volatility in financial markets as a brief blip and affirmed its plans to raise its benchmark interest rate in the coming months.
The Fed painted economic conditions in bright and happy colors in its biannual report to Congress on the conduct of monetary policy. It said the labor market was “near or a little beyond full employment,” an important milestone in the recovery from the 2008 crisis.
“The U.S. economy appears to be performing very well and, certainly, is in the best shape that it has been in since the crisis and, by many metrics, since well before the crisis,” Randal K. Quarles, the Fed’s vice chairman for supervision, said Thursday in Tokyo.
The immediate problem confronting the Fed is how quickly to raise interest rates. The Fed forecast in December that it would raise rates three times in 2018, just as it did in 2017. Fed officials say stronger growth is fortifying those intentions, and the next rate increase is expected in March. A growing number of Wall Street analysts predict the improving economic forecast will persuade the Fed to raise rates four times this year.
The hot topic on Friday, however, at a conference attended by several Fed officials in New York, was whether the Fed would be ready for the next economic downturn.
The Fed’s benchmark rate is in a range of 1.25 percent to 1.5 percent, and the Fed does not expect it to rise much higher than 3 percent in the current economic expansion. That’s a problem given that, in the last four downturns, the Fed has cut rates by an average of 5.5 percentage points to stimulate renewed growth.
During the last downturn, the Fed reduced the benchmark rate to nearly zero in 2008, and then supplemented its efforts by pledging to keep interest rates at a low level and by purchasing large quantities of Treasuries and mortgage-backed bonds.
Fed officials have said that those policies benefited the economy, and could be used again during a future downturn. Other central banks have relied on similar policies in recent years, and have reached similar conclusions. Benoît Cœuré, a board member of the European Central Bank, said economic research was “fairly clear” that such asset purchases helped to hold down interest rates.
But the main paper presented at the conference on Friday, which is hosted by the University of Chicago’s Booth School of Business, asserted that bond-buying had little economic benefit.
“Our conclusion is that the most important and reliable instrument of monetary policy is the short term interest rate,” wrote the authors, a team of two academics and two bank economists-
The danger of a rapid return to near-zero interest rates seemed particularly acute in the immediate aftermath of the 2008 financial crisis, as the Fed repeatedly delayed any increase in rates. Now, the economy has gained strength and the Fed has raised rates five times. Jan Hatzius, chief economist at Goldman Sachs, said the progress showed the Fed’s policies had helped, and that the Fed might be able to raise interest rates above current expectations.
“My own view about what is possible at the zero lower bound is quite a bit more optimistic than it was back then,” Mr. Hatzius said.
An account of the Fed’s most recent policymaking meeting, in January, reported that some officials had shared that optimism, expressing the view that the Fed might be able to increase its benchmark rate somewhat closer to its precrisis level.
Nonetheless, there is growing support among Fed officials for a review of the Fed’s approach to policy, and of alternatives that might allow it to respond more forcefully to future downturns.
Loretta Mester, the relatively conservative president of the Federal Reserve Bank of Cleveland, told the conference she favored starting such a study “later this year.”
The Fed aims to keep inflation at an annual pace of 2 percent a year, by raising and lower interest rates and by training the public to expect a certain level of inflation, disciplining the pricing decisions of businesses and the wage demands of workers.
Alternative approaches fall into two broad categories: Permanently replace the Fed’s 2 percent target, or set it aside in the aftermath of downturns.
Raising the target is a simple way of creating more room to respond to crises. Interest rates include expected inflation, so higher inflation would raise rates.
Embracing higher inflation, however, could cause political problems for the Fed.
Alternatively, the Fed could tolerate higher inflation on a temporary basis. For example, the Fed could aim to maintain average inflation at 2 percent over some specified period, meaning that it would compensate for periods of lower inflation, as during the last six years, by allowing periods of higher inflation, thus maintaining a 2 percent average.
Last year, the Fed began to include a comparison between its actual management of interest rates, and the results produced by alternative approaches to monetary policy.

The report on Friday included an inflation-averaging approach among those alternatives for the first time.