Conditional Inflation Targeting in Effect

Nearly a year ago, Jeffry Frieden and I called for Conditional Inflation Targeting. Today, policy seems to have turned toward that direction. From today’s statement from the FOMC:

…the Committee decided to keep the target range for the federal funds rate at 0 to 1/4 percent and currently anticipates that this exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6-1/2 percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored. …

The Fed had earlier conditioned its asset purchases on the state of the economy, and continues to do so (although replacing Operation Twist with outright purchases). But today, the Fed provided explicit numerical reference points to condition the policy regarding the setting of the Fed funds rate. From our Foreign Policy article:

[We need] inflation — just enough to reduce the debt burden to more manageable levels, which probably means in the 4 to 6 percent range for several years. The Fed could accomplish this by adopting a flexible inflation target, one pegged to the rate of unemployment. Chicago Fed President Charles Evans has proposed something very similar, a policy that would keep the Fed funds rate near zero and supplemented with other quantitative measures as long as unemployment remained above 7 percent or inflation stayed below 3 percent. Making the unemployment target explicit would also serve to constrain inflationary expectations: As the unemployment rate fell, the inflation target would fall with it.

Today our highest priority should be to stimulate investment, growth, and employment. Raising the expected inflation rate will lower real interest rates and spur investment and consumption. It will also make it difficult for the de facto dollar peggers, such as China, to sustain their policies. The resulting real depreciation of the dollar would stimulate production of U.S. exports and domestic goods that compete with imports, boosting American production. The United States would get faster growth, an accelerated process of deleveraging, a quicker recovery, and a firmer foundation upon which to address long-term fiscal problems.

The actual unemployment rate, NAIRU, and threshold unemployment rate are presented in Figure 1. Figure 2 presents the actual CPI-all inflation rate (y/y), the forecasted inflation rate a year from November, and the inflation threshold.

Figure 1: Actual unemployment (blue), nonaccelerating inflation rate of unemployment (CBO NAIRU) (red), and 6.5% threshold (black dashed line). NBER defined recession dates shaded gray. Source: BLS, CBO (August 2012), and NBER.

Figure 2: Actual CPI inflation year-on-year (blue), and average forecasted inflation for November 2013 (red square), and 2.5% threshold (black dashed line). NBER defined recession dates shaded gray. Source: BLS, Survey of Professional Forecasters (November 2012), and NBER.This move is no panacea for the economy’s challenges, and certainly would not completely offset the shock arising from a complete implementation of the fiscal slope, but it’s a step in the right direction.

See also: [1][2], and Thoma on thresholds vs. triggers.

This piece is cross-posted from Econbrowser with permission.