2%, 3%, or 4%?

Unless explicitly stated, views expressed do not constitute official PIMCO views.

When will the Fed pivot? This has been the question of the week from clients, journalists, and investors. On Tuesday, I spoke on a NABE (National Association for Business Economics) conference panel with economist Austan Goolsbee, and although the panel topic was "the outlook for inflation," the focus of audience questions was on the financial market constraints faced by central banks (e.g., elevated leverage and the possibility of financial market accidents), and whether this would limit their ability to (1) raise rates further and (2) keep them at restrictive levels for any length of time. As we discussed in last week's note, the central bank's blunt interest rate and balance sheet tools make its job of arresting inflation a difficult one (see Macro Signposts, Inflation and Financial Market Dominance | 04 October 2022).

For now, the Fed appears happy to err on the side of risking a more severe U.S. recession to bring down inflation. This mindset is likely to remain in place while inflation is elevated and unemployment is low. However, next year, when the U.S. will likely be in the midst of what we expect to be a shallow but more prolonged recession, unemployment will probably have overshot above estimates of NAIRU (the nonaccelerating inflation rate of unemployment), and inflation will probably have moderated (although likely not yet to target), the trade-off that the central bank faces will be different, and the Fed's focus will likely shift to adjusting policy back to neutral, or even back toward easy policy in the event of a more severe recession.

Taking a step back, there is a deeper, more interesting question around the Fed's willingness to enact policy to push the unemployment rate higher in the event that inflation remains sticky above the 2% long-term target. And although commentators and policymakers alike have been keen to review lessons learned from the 1970s and 1980s inflationary period, the lessons of the 1990s are perhaps more relevant to answering this question.

Against a backdrop of 9% U.S. inflation, Fed Chair Jerome Powell, in not so many words, has pledged to follow in the footsteps of his predecessor, Paul Volcker, by setting real rates at a sufficiently restrictive level to moderate elevated inflation and to "not stop until the job is done" (for example, see Chair Powell's Jackson Hole Speech: Monetary Policy and Price Stability). Interestingly, however, Chair Volcker didn't actually sustainably return inflation to 2% – what is now known as the Fed's long-term inflation goal. Indeed, the Volcker Fed successfully reduced inflation from a peak rate of 14.5% to 4% through a lengthy recession in the early 1980s; however, it look 20 years and two more recessions before a five-year period of 2% average inflation was achieved.

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

As described by Orphanides and Wilcox in their 1997 seminal paper on opportunistic disinflation, the key element of this strategy was that when inflation was elevated, the central bank set policy at a sufficiently restrictive level so as to push inflation back down toward target. However, once inflation had moderated below a threshold – in the 1990s, that threshold appeared to be between 3%–4% – the Fed behaved asymmetrically, attempting to guard against reacceleration, but avoiding tightening policy to the point that it created further downward pressure on real economic activity or employment. In other words, the Fed dropped real rates by less than implied by a Taylor rule during downturns characterized by above-target inflation (but that was still below the threshold) and left real rates at their estimated neutral level during periods of stable growth, while inflation was running below the threshold but still above the target.

While inflation is running at 9%, the Fed clearly believes it must continue to maneuver as if it is a single mandate central bank. However, the extent to which the Fed's strategy shifts as inflation moderates, albeit to a still above-target pace, remains to be seen, but we think there are good arguments to at least consider revisiting this 1990s strategy:

First, by many accounts, the Fed's conduct of monetary policy during the 1990s period has been deemed a huge success. Admittedly, constructing counterfactuals is complex and sensitive to underlying assumptions, but it is hard to argue that the economic outcomes starting in the late 1980s 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 which was also characterized by significant macroeconomic stability (for more discussion, see Mankiw, 2001¹). This, in turn, ushered in a period of heightened private tech investment in the early 1990s that contributed to the productivity boom in the latter part of the decade.

Second, there is no special magic in the number "2." Indeed, the numeric 2% inflation target was first introduced by the Reserve Bank of New Zealand (RBNZ) in 1988, through heavy public promotion of the central bank's price stability goal aimed at influencing wage contract negotiations. RBNZ officials committed to a numeric 0%–2% range as a medium-term target, because after a period of elevated inflation, they wanted to increase the credibility of moderately higher 3%–5% interim targets. The specific level was the result of a known upward bias in the official inflation statistics measurement methodology of around 1.8% relative to the "true" underlying inflation (for more see, "Origins and Early Development of the Inflation Target"). The relative success of the RBNZ strategy ushered in a wave of other central banks formalizing numeric 2% targets.

Furthermore, there is a wealth of economic research on the costs of elevated inflation. For example, high inflation is usually also more volatile, and creates greater uncertainty for wage setters, savers, lenders, and investors. It can also result in an arbitrary redistribution of wealth, impose high "menu costs" on businesses (transaction costs of changes in prices rise with more frequent price changes), and contribute to nominal tax code distortions (for more, see Mankiw, 2006²). The costs of zero inflation and outright deflation are also well known: This results in greater interest rate proximity to the zero lower bound constraint faced by the central bank, and the existence of nominal wage rigidities might also result in higher rates of unemployment than would otherwise occur. Nevertheless, there is less formal research on the welfare gains (or losses) of a 2% target vs. a 3% or 4% target, and in principle, the Fed should be able to achieve stable inflation at whatever target they choose. In 1994, Larry Ball argued for a 4% target (see Ball, 2014), while more recently, Jason Furman has argued 3% may be a better number (see Furman, 2021³).

Third, empirical evidence is mixed as to what extent the so-called "sacrifice ratios" – i.e., the amount of unemployment rise needed to reduce inflation by 1 percentage point – have declined as a result of the 1990s emergence of central bank numerical inflation commitments, implying that the potential costs to credibility of holding an implicit interim target moderately above 2% might not be that great. Studies have shown that a country's labor market structure and the flexibility in wage-setting contracts are also important, with countries with a greater flexibility of wage setting exhibiting a lower cost of disinflation (see Ball, 1994⁴).

Furthermore, although central banks have a well-established history of political independence, the economic pain of driving employment down further in the case that inflation remains sticky above target isn't costless for society. Based on the experience of developed market economies since the 1960s, we estimate that around 1 percentage point of incremental unemployment is needed to reduce the realized inflation rate by 1 percentage point. According to this estimate, if inflation is expected to remain sticky at 4%, then the Fed would need to enact policy to raise the unemployment rate by 2 percentage points to above 5% to moderate inflation back to target. However, estimates can vary based on estimation method, and unemployment rate rises can take on momentum of their own.

Of course, 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, for example, calls its general strategy a flexible average inflation targeting approach, the numeric target arguably reduces the flexibility to explicitly change the target or announce an interim inflation threshold. Powell and other central bank officials have been very clear in their unwillingness to revisit or change the 2% long-run goal, for fear of the implications to credibility. Nevertheless, if inflation moderates from 9% to 3% or 4%, the Fed could have some credibility leeway to take some more time to get back to 2%. Indeed, in the context of the formal 2% inflation target, core PCE (Personal Consumption Expenditures) inflation had averaged 1.5% to 2.0% for much of the post-global-financial-crisis, pre-pandemic period. Moving forward, why couldn't the Fed allow inflation to realize above 2% for a time, while still projecting it to converge over a longer period?

This report, like future reports, summarizes the vast array of data analysis that we do at PIMCO. Please don't hesitate to ask us about the underlying data and analysis. If you would like to reach out to us, please e-mail [email protected].

¹ N. Gregory Mankiw, "U.S. Monetary Policy During the 1990s" (National Bureau of Economic Research, September 2001)

² N. Gregory Mankiw, "The Inflation Tax" (Greg Mankiw's Blog, May 2006)

³ Jason Furman, "What the Federal Reserve Should Do Now: An Elaboration" (Peterson Institute for International Economics, November 2021, updated February 2022)

⁴ Laurence Ball, "What Determines the Sacrifice Ratio?" (National Bureau of Economic Research / The University of Chicago Press, January 1994)

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