Managing Tail Risks with Monetary Policy
“This may come as a surprise to some of you, but I am not a fine-tuner. I think that the objective of the Federal Reserve ought to be to avoid a very bad outcome, and so my concerns are primarily with tail risks on both sides of our mandate.” - Ben Bernanke, June 2008 Federal Open Market Committee meeting.
As was true in June 2008, the Federal Open Market Committee (FOMC) is facing key upside and downside tail risks to achieving its monetary policy objectives. The first is upside risk to inflation expectations. It is possible that, with the strengthening labor market, wage inflation will accelerate. If that wage inflation transpires, it is possible that, despite unusually high profits, businesses will choose to pass those wage increases along to consumers. And it is possible that, if higher wage and price inflation occurs, inflation expectations could become unmoored and move well above desirable ranges.
The second is downside risk to inflation expectations. In many major countries, central banks and elected representatives lack the capacity and/or will to insulate their citizens against adverse demand shocks. As a result, there is a wide array of possible contingencies that could trigger a new flight to safety to the US dollar and US dollar-denominated assets. The upward pressure on the dollar would put further downward pressure on US inflation and on inflation expectations. The resulting higher real interest rates would also create a potentially significant drag on growth and employment.
I have two comments about how the FOMC should structure its policy stance in order to deal with these two tail risks. The first comment is that the Committee’s emphasis on gradualism is misplaced. The second comment is that the Committee should lower the target range for the fed funds rate by a quarter percent.
First: The FOMC has communicated that its current strategy is aimed primarily at gradual normalization - that is, the Committee has a strong desire to raise the target range for the Fed funds rate slowly over time. But this communicated strategy is not well-designed to confront either of the two tail risks. If the Committee does in fact see a danger of inflation expectations becoming unanchored to the upside, it needs to react by rapidly raising the target range of the fed funds rate. If the Committee does in fact see further disinflationary pressures, it should ease policy sharply.
The FOMC’s emphasis on gradualism as a core objective of policy has communicated its unwillingness to respond to either tail risk. Unfortunately, this communication only serves to make it more likely that inflation expectations could become unmoored in either direction.
Second: The current level of the fed funds rate target range seems misaligned with the balance of risks. The first upside risk results from a chain of three links (accelerating wage inflation, pass-through of wage inflation to price inflation, and then upward drift in inflation expectations). All of these risks seem unlikely to me. Much more importantly, even if I’m wrong, the Federal Reserve has well-proven tools with which to manage this risk through tighter policy.
In contrast, we see clear signs that the second downside risk is much more material. The behavior of financial markets over the course of this year reflects a great deal of apprehension about global growth prospects. As well, market-based measures of both near-term and long-term inflation expectations remain very low. Even more troublingly, the Fed has limited capacity with which to manage downside tail risk, if it were to occur.
These considerations argue that the current stance of monetary policy should put a lot of weight on insuring the economy against downside risks. Accordingly, at next week’s meeting, the FOMC should lower the fed funds rate target range by a quarter percent.
N. Kocherlakota
Rochester, NY, March 9, 2016
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