Countering Downward Bias in Inflation

GIC and Banco de México
February 27, 2020
Mexico City, Mexico

Charles L. Evans
President and CEO
Federal Reserve Bank of Chicago

The dual mandate bullseye, showing target of 2% inflation and 4.1% unemployment. We are near those targets, but slightly under both.
The views I express here are my own and do not necessarily reflect the views of the Federal Open Market Committee (FOMC) or within the Federal Reserve System.

Key Messages

  • Effective Lower Bound (ELB) risk leads to downward bias in inflation
  • When ELB drives down π < π* for an extended period, need to follow with some period of π > π* in order to establish E[π] consistent with symmetric target

Low Trend Growth and Low Neutral Interest Rates (r*)

US (percent)

Trend growth fell sharply from it's peak in 1999. However, for the last few years it has been rising. Estimated real r* has also fallen sharply since 1999, but has been more volatile since then. Currently it has ticked higher.

Advanced Economies (percent)

A line graph showing the rate of trend growth and the estimated real r* rate. Both fell sharply around 2009, but both have recently risen.
Estimates for Advanced Foreign Economies are GDP-weighted averages across the US, Canada, the Euro Area, and the UK using OECD estimates of GDP at purchasing power parity. Prior to 1995, Euro-Area weights are the summed weights of the eleven original euro area countries. Sources: Laubach and Williams (2003); Holston, Laubach, and Williams (2017); FRBNY

Undershooting Inflation Goals

Deviation from Central Bank Inflation Target

Bar graph showing the deviation from central bank inflation target for the U.S., U.K., Euro Area, and Japan. Japan has had the most deviation, and the U.S. has had the least.
Source: Various statistical collection agencies from Haver Analytics

Conventional Monetary Policy Easing During Past Recessions

Federal Funds Rate (percent)

Average easing during recessions 500 bps
Current fed funds rate range 150-175 bps
Long-run neutral rate 250 bps
Line graph showing the Federal Funds Rate since 1980. It was at its highest in the early '80s, then was near zero for about 5 years. It has recently been lowered.
Source: Board of Governors of the Federal Reserve System from Haver Analytics

Fed Funds Rate and a Traditional Benchmark

Federal Funds Target Rate (percent)

Taylor Rule (1999):
r(t) = r*(t) + π(t) + 0.5[ π(t) – π* ] + 2[ uLR(t) – u(t) ]

A line graph showing the Federal Funds Rate and teh Taylor Rule. They line up prettey well except for a period between 2009 and 2015, when the Federal Funds Rate was at 0 at the Taylor Rule dropped below 0.
r*(t) and uLR(t) from Blue Chip Consensus Forecast.
Source: Board of Governors of the Federal Reserve System from Haver Analytics

Offsetting ELB Downward Inflation Bias

  • Heightened risk of ELB
    • Downward bias in inflation
    • Risk of E[π] < π*
  • To offset bias, likely need π > π* for some period of time so that:
    • E[π] is firmly anchored at π*
    • π = π* in the medium term
  • Embrace approaches aimed at these bias-adjusting outcomes

Outcome-Based Approaches

  • Overarching aim: achieve dual mandate goals
  • To do so, monetary policy must commit to:
    • Provide extraordinary policy accommodation during and after ELB episodes
      • Prescriptions from simple rules (e.g., Taylor) are inadequate
    • Generate periods of π > π* to offset ELB downward inflation bias
      • Recognize π > π* is required more than in non-ELB world
      • Convey to public that periods of π > π* essential to achieve dual mandate over long haul
      • The outcome of E[π] = π* is key
  • A number of ways to operationalize this

Example: State-Contingent Price Level Targeting

Core PCE Price Index

A line graph showing the Core PCE price index since 2004, projected out to 2025. The current gap is 5.3%.
Source: Bureau of Economic Analysis from Haver Analytics and staff calculations

Example: Asymmetric Policy Response

  • Respond more aggressively when inflation below target than when inflation above target: Bianchi, Melosi, Rottner (2020)
  • Adjust the standard Taylor Rule

    r(t) = r*(t) + π(t) + λ[ π(t) – π* ] + 2[ uLR(t) – u(t) ]

    • If π(t) < π*, larger λ
    • If π(t) > π*, smaller λ

Evans’s view: Inflation objectives that have a point target, such as 2 percent, are easier to communicate than objectives defined by an inflation range. As I discuss next, using a range requires even more attention to asymmetry.

Example: Inflation Ranges [πL < π* < πU ]

  • Alternative #1: Harris (2016); Mertens and Williams (2019)
    • Recognize that inflation will be driven to πL when at ELB
    • Aim for higher inflation πU away from ELB to average π* over time.
  • Alternative #2: Bianchi, Melosi, and Rottner (2020)
    • When inflation is in range, react less aggressively
    • But set range asymmetrically about target
      • e.g., if π* = 2%, then πL = 1.5%, πU = 2.85%

Example: Inflation Ranges [πL < π* < πU ]

  • Alternative #3: Symmetric Range of Policy Indifference
    • When inflation is in range, do nothing. Say we can go home—that’s good enough for government work

Example: Inflation Ranges [πL < π* < πU ]

  • Alternative #3: Symmetric Range of Policy Indifference
    • When inflation is in range, do nothing. Say we can go home—that’s good enough for government work
  • Won’t cure ELB downward inflation bias

Properties of Asymmetric Responses and Range Alternatives #1 & #2

  • Parameters can be set so that inflation will average π* over long periods of time
  • Do not require mechanical makeup for past periods of inflation away from target

Some Questions

  • Can policymakers credibly commit to pursuing the policies prescribed by some of these alternatives?
  • How will central banks communicate these strategies effectively?
  • How will the public react to protracted periods of π > π*?
    • Will long-run inflation expectations move up? By how much?
  • What are the financial stability implications of the highly accommodative policies prescribed by the alternatives?

My Key Considerations

  • Focus on outcome-based strategies
    • In the U.S., focus on the dual mandate
    • When ELB drives down π < 2%, likely need follow with period of π > 2% to get inflation expectations consistent with target
  • Given ELB, any operational framework will need to use unconventional tools (e.g., QE, forward guidance)
    • Effectiveness of these policies will influence the policy parameters of the alternative frameworks
  • Address potential financial stability risks with regulatory and supervisory tools
  • Credibility is key and essential for any operational framework
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Countering Downward Bias in Inflation—Slides

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