Macro Signposts | 7 May 2024

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Is Fed Policy Returning to Opportunistic Disinflation?

The Federal Reserve's view on interest rate risks has fundamentally changed since last year, when Fed Chair Jerome Powell indicated some pain in labor markets would likely be needed to tame inflation. At the press conference following last week's Fed meeting, Powell acknowledged that sticky inflation means rate cuts will come later than previously expected, but with policy still restrictive, officials did not seriously consider additional hikes.

Instead, officials seem attentive to downside risks, such as rising unemployment, and appear ready to cut rates were the U.S. economy to deteriorate. With inflation having fallen dramatically from its peak, the Fed now appears comfortable to let it hang above the 2% target for a while.

Fed officials may not admit it, but this new approach feels akin to its opportunistic disinflation strategy of the 1990s.

Back to the 1990s?
Over the last few years, amid the inflation surge, Powell appeared determined to follow the approach of former Fed Chair Paul Volcker as Powell sought to moderate elevated inflation and "not stop until the job is done." Indeed, Powell has presided over one of the fastest disinflations in U.S. history, with remarkably little pain in labor markets. Still, inflation isn't yet fully back to target, and now seems stuck in 2.5% to 3.5% range, depending on the measure.

Interestingly, the Volcker-led Fed also didn't sustainably return inflation to 2% – what is now the Fed's long-term inflation target. But it did reduce inflation from 14.5% to 4% through a lengthy recession in the early 1980s. It took 20 years and two more recessions before the U.S. economy experienced a five-year period of 2% average inflation.

Why did inflation in the 1990s remain stubbornly above the level that officials considered consistent with the price stability mandate? In our view, it was due at least in part to a deliberate policy choice: the Greenspan-era monetary policy strategy of "opportunistic disinflation."

In their seminal 1997 paper, "The Opportunistic Approach to Disinflation," Athanasios Orphanides and David W. Wilcox describe the strategy through monetary-policy-type rules that say when inflation is elevated, the central bank should set policy at a sufficiently restrictive level so as to push inflation back down toward target. However, once inflation moderates below a threshold – in the 1990s, it appeared to be between 3% and 4% – the Fed should behave asymmetrically, attempting to guard against reacceleration, but avoiding tightening policy to the point that it creates further downward pressure on real economic activity or employment. The hope was that eventually a recession (or productivity boom) would come along and bring inflation back to target.

Potential benefits in today's macro cycle
As we discussed in Macro Signposts back on 12 October 2022, there are potential economic benefits to tolerating some above-target inflation, and there are arguments in favor of employing this type of strategy now.

First, policy stability can reduce business uncertainty, leading to periods of capital deepening and rising productivity. By many accounts, the Fed's conduct of monetary policy during the 1990s was a success. Constructing counterfactuals relies on uncertain assumptions, but it is hard to see how the economic outcomes of the late 1980s and 1990s could have been improved by an alternate monetary policy approach. Through the second half of the 1980s, the U.S. economy achieved sustained 4% real GDP growth and a sizable drop in the unemployment rate. This set the stage for further disinflation at a lower fed funds rate in the mid-1990s – a period characterized by significant macroeconomic (and interest rate) stability that, in turn, fostered heightened private tech investment that contributed to the productivity boom in the late 1990s. There are parallels to today: The increased spending needed to transition the global economy toward increased digitalization, renewable energy, and more resilient supply chains would almost certainly benefit from steady central bank policies.

Second, there isn't necessarily some special magic in the number "2." Indeed, the numeric 2% inflation target was introduced in 1988 by the Reserve Bank of New Zealand (RBNZ) when it committed to a 0%–2% range as a medium-term target, acknowledging a known roughly 2% upward bias in the official inflation statistics.¹ The relative success of the RBNZ strategy ushered in a wave of other central banks formalizing numeric 2% targets. However, 2% just as easily could have been 3% or even 4%. Larry Ball has argued for a 4% target,² and more recently, Jason Furman has advocated for 3%.³ Assessments of the real neutral rate may inform inflation targets as well – low neutral rate environments might benefit from somewhat higher central bank inflation targets. In principle, the Fed should be able to achieve stable inflation at whatever target it chooses.

Third, the so-called sacrifice ratio – i.e., the amount that unemployment must rise to reduce inflation by 1 percentage point – is probably nonlinear, and definitely uncertain. In the current cycle, high levels of job openings have meant only a small rise in the unemployment rate has coincided with the current disinflation. However, with the ratio of job openings to unemployed now getting closer to pre-pandemic levels, the unemployment rate may need to go higher for inflation to drop to and sustain 2%.

Considerations and risks of above-target tolerance
A key difference between now and the 1990s is the formalization of numeric targets that are now held by most developed market central banks. Although the Fed calls its current strategy a flexible average inflation targeting approach, its 2% numeric target likely reduces flexibility to change the target or announce an interim inflation threshold. Powell and other Fed officials have been very clear in their unwillingness to revisit the 2% long-run goal, for fear of jeopardizing credibility. Nevertheless, as U.S. CPI inflation has already moderated from 9% to just below 4%, the Fed probably has some leeway to take more time to get all the way back to 2%.

There are drawbacks to an opportunistic disinflation strategy. While the strategy helped maintain general macroeconomic stability and low inflation, the 1990s was a period of booms and busts in financial markets. This decade saw the buildup of financial imbalances, including speculative investments in Asian real estate and stock markets, which turned into a currency crisis, and in the U.S., the dot-com bubble episodes that some observers argue were partly due to the prolonged period of generally stable interest rates. Although financial stability risks currently appear manageable, building leverage over time could eventually cause similar problems.

Trading higher prices for macro stability?
After big moves in interest rates over the last few years, the U.S. may be poised for a period of elevated but relatively stable rates. Stable growth, low unemployment, and modestly above-target inflation is an economic mix that could keep the Fed from either aggressively cutting or aggressively hiking. Perhaps such a period would feel similar to the 1990s, and usher in a capital spending boom that fuels the economic transformations promoting future productivity. Or, we could be sowing the seeds for tomorrow's financial stability risks.

¹ Redell, Michael, "Origins and early development of the inflation target," Reserve Bank of New Zealand: Bulletin Vol. 62, No. 3 (1999)
² Ball, Laurence M., "The Case for a Long-Run Inflation Target of Four Percent," International Monetary Fund eLibrary, 9 June 2014
³ Furman, Jason, "What the Federal Reserve Should Do Now: An Elaboration," paper prepared for delivery at the Peterson Institute for International Economics, 18 November 2021

Read the previous edition of Macro Signposts on an approach to macro forecasting informed by behavioral science.

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