There’s a flaw at the heart of central banking’s approach to inflation targeting that’s become a hot issue for the Federal Reserve as it takes a long, hard look at its strategy.
For decades, central bankers have pursued price goals while saying financial stability risks are better curbed by regulation. The contradiction is that monetary policy is often the most powerful fuel for asset bubbles as central bankers hold interest rates low to try and lift inflation that remains weak despite solid growth and rising productivity.
That describes the U.S. today, with stocks trading at record highs and financial conditions easy. As central bankers meet Tuesday and Wednesday, they’ll see an economy growing strongly while the core inflation rate slowed to 1.6 percent last month. That’s well below their 2 percent goal and continues a persistent undershoot which has prompted a year-long review of the Fed’s price strategy.
“A big part of the policy rethink has to be making the costs and benefits of these trade offs more rigorous and explicit,” said Julia Coronado, founder of MacroPolicy Perspectives LLC in New York. “How much signal do they want to take from the turn down in core inflation given the growing leverage in the corporate sector that could make the next recession deeper?”
Central banks elsewhere have wrestled with striking that balance and the conflict resulted in the resignation in Sweden in 2013 of Riksbank Deputy Governor Lars E.O. Svensson. He stepped down after his colleagues ignored his calls for deeper rate cuts because they were worried about fueling unsustainable credit growth.
Just last month Fed officials were divided over whether to raise a capital buffer on the largest banks. They’ll include a panel on financial stability at a Chicago conference in June on the conduct of monetary policy.
“If financial conditions ease, growth will be higher and monetary policy should respond” with tighter policy, said former Fed Governor Laurence Meyer. Yet central banks’ response to financial risk is often a story of “not yet, not yet, not yet – too late!’’
U.S. central bankers sound intent on getting inflation higher, after missing their target almost continually since adopting it in 2012. Officials worry that if they can’t hit 2 percent inflation amid strong growth and low unemployment they may never get there.
Such concern was reflected in the Fed’s pivot to keeping rates on hold this year, which has boosted financial assets, and tilted the flow of money toward riskier investments. Larry Fink, the chief executive officer Blackrock Inc., the world’s largest asset manager, told CNBC April 16 that there is greater risk of a stock market “melt up’’ than meltdown.
Economists expect the Fed to ignore market froth, leaving the policy rate on on hold in a range of 2.25 percent to 2.5 percent at the conclusion of their meeting Wednesday, while expressing concern over “muted” inflation. It’s a tricky subject for the Fed to navigate without sending mixed signals to the markets.
New York Fed President John Williams, prior to the rate hike in December, said an increase had the “added benefit’’ of reducing financial imbalances. As stocks plunged after the move, Williams said the Fed is “listening very carefully to what’s happening in markets.’’
Fed officials discuss financial stability risks at most policy meetings. The Fed Board in Washington even publishes a semiannual report focused specifically on financial risks. But the committee’s communication on the topic can appear confusing and contradictory.
Minutes from the March 19-20 FOMC meeting show “a few” officials worried about growing financial stability risks and a couple pushed to trigger a requirement for big banks to build bigger capital buffers to guard against a downturn. Yet earlier that month the Board voted 4-1 not to do so, with Governor Lael Brainard dissenting.
“How much froth in leveraged lending is the Fed willing to tolerate in exchange for 20 basis points on inflation?,’’ Coronado asked a New York Fed advisory panel earlier this month.
Fed Chairman Jerome Powell will likely face similar questions at his post-meeting press conference Wednesday. He told reporters last month that the linkage between monetary policy and financial stability is an “unsettled and difficult” question and the first option is regulation and supervision.
Fed officials are asking, “‘What is the alternative, what can we do?’’’ said Seth Carpenter, a former adviser to the Fed Board who is now chief U.S. economist at UBS Securities LLC. “Greenspan’s answer was, ‘Well that is just capitalism,’ and that didn’t turn out very well,’’ he said, referring to former Fed chief Alan Greenspan.