the Fed’s new inflation stance

Fed Chair Powell, speaking virtually at what would otherwise be the annual monetary policy conference in Jackson Hole, Wyoming, set out a new protocol yesterday for what the Fed would do if the US ever had inflation (a sustained period in which prices in general rise) again.

The old policy was to begin to choke back economic growth by raising interest rates once price increases started to roll, with the objective of holding inflation at or below a 2% annual rate. The new policy is basically to not be so eager, but rather to sit back for a while and see what happens.

Why the change? What does it mean?

some context first

The late 1970s was a baaad time for the US economy. Politicians had successfully arm-twisted the Fed into running an extra-loose money policy for most of that decade. This ended up creating runaway inflation, an economy-killing disease thought to only be found in the worst third-world countries (and Weimar Germany, of course). Prices were rising at close to an 8% clip in 1978, with 11% in prospect for 1979 and progressively bigger figures after than.

Families began to turn their paper money into physical things as fast as they could so that inflation wouldn’t eat into value. They accumulated large inventories of everyday items, on the idea that they’d only be more expensive later on. This hoarding itself drove prices up more. Companies began to borrow heavily, thinking they’d make money just by repaying fixed-rate loans in inflation-diluted dollars. They used the funds to acquire hard assets–real estate developments or gold mines or cement plants or ships–that had absolutely nothing to do with their core businesses but which they told themselves would be inflation-proof and maybe even rise in value.

To shatter the belief in ever-rising prices, and the loony-tunes behavior it sparked, Paul Volcker raised the fed funds rate to 20% in early 1980 and kept it ultra-high until mid-1981, causing a deep recession. This also made prices fall, breaking the inflationary spiral that had developed in the late 1970s. This left families trying to figure out what to do with eight years’ worth of canned goods and corporate boards stewing about their brand-new gold mines–just as the gold price began a fourteen-year swoon.

a 2% target

As inflation and nominal interest rates both continued to decline for decades (the 10-year Treasury yieldid about 5.7% in 1999), theoretical economists began to discuss what the ideal inflation rate might be. They arrived at 2% as their ultimate goal. The Fed decided to see if it could accomplish this with the real economy.

And it succeeded. Some years ago, however, it and other national central banks began to realize that while they’d done a bang-up job getting interest rates down, they had somehow lost the ability to get them, even temporarily, to move in the other direction. What was once an aspirational downside goal had suddenly become an unattainable ceiling.

How so? Who knows. The result is that the world has been constantly been flirting with deflation–the bane of the Great Depression of the 1930s. Whoops.

back to Powell’s statement

I think he’s saying two things:

–given the gigantic amount of government debt run up by Trump administration bungling and its questionable decision to fund the lion’s share in very short-term instruments (which disguises the extent of the damage but puts the country at risk should rates begin to rise), he is not about to create a new crisis by prematurely raising short rates

–given that monetary theory has trapped us in a place where traditional policy tools don’t work so well, Powell would like to see us well above the 2% line before he begins to tighten

Yields went up by a mere 0.05% on the announcement, meaning Wall Street had been assuming the Fed would remain an island of calm in a sea of administration economic madness.

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