Diana A. Cooke and Wiliam T. Gavin of the St. Louis Fed’s Regional Economist do an excellent job in explaining the role of Fed credibility on inflation. Inflation is the rise in overall prices and its measure is critical in determining the overall health of an economy. Even though some inflation is actually healthy, high rates of inflation erodes wealth and causes investor and consumer uncertainty. Also, deflation can be even more damaging as businesses struggle to make ends meet due to an inability to raise prices. That is why investors and the business community values any insight on predicting future inflationary trends.
There is historical relevance of Fed credibility and the trend of inflation. The Fed is represented by the Federal Open Market Committee that sets interest rates through conventional means, such as open market operations, discount rate, and reserve requirement, and non-traditional methods, such as quantitative easing, referred to as large scale asset purchases by Bernanke. If you want to learn more both methods, view this lecture from former Fed Chairman Ben Bernanke.
Specifically, look at the video between 8:40 to 12:40 where Bernanke discusses the Fed’s conventional methods in controlling monetary policy. From 12:41 to 19:09, he talks about non-conventional methods.
Now referring back to Fed credibility and its impact of inflation, we noticed the following trends:
In the 1970s, the Fed had little credibility and that is one of the reasons why inflation was high at that time. This goes back to the last of the ten principles from Mankiw, which states that there is a short-run tradeoff between inflation and unemployment. Mainly due to Middle East unrest that drove oil prices very high, the U.S. economy suffered from high rates of inflation. This stunted economic growth and in an attempt to boost job growth, the Fed pursued easy money strategy to keep interest rates low. However, the market frowned upon this action and that drove inflation even higher. This is shown with the graph from Cooke and Gavin below:
Notice how the Fed Funds Rate which is shown in red was driven down around the mid-1970s. During that period, inflation was very high.
It was not until late 70s and early 80s where we see the Fed Funds Rate raised in order to fight inflation. This move eventually killed high inflation, but it came at a cost of higher unemployment and two recessions. It was during this period, described as 1980-1986, where the Fed regained its credibility and that was a main contributor to falling prices.
This credibility held true for the next twenty years (1987-2007) where inflation remained modest. However with the onset of highly irregular monetary policy, the Fed pursued drastic measures to stabilize an economy on the brink of collapse due to deteriorating financial institutions that were penalized for its poor lending practices.
Even though the Fed’s efforts during this recent crisis was more extensive than the 1970s and one would expect Fed credibility in managing inflation to diminish, we still have not seen a rise inflation. While this is puzzling, Cooke and Gavin believe we can look to the Fisher Effect to understand why inflation has been so sluggish.
The Fisher Effect was developed by Irving Fisher in his 1930 publishing of The Theory of Interest. It basically explains how the nominal interest rate is a function of the real interest rate and inflation expectations through this accounting expression:
Nominal interest rate = Real interest rate + Expected inflation rate
While nominal interest rates are expressed as the rate paid by individuals that want to borrow money or earn on funds held in savings accounts, the real interest rate is adjusted to account for inflation. Since no one knows what inflation will be in the future, people guess what it will be. Cooke and Gavin provide an example of how this works through the following example:
Suppose an investor is willing to lend $100 for a real rate of return of 3 percent and they expect inflation to rise by 2 percent next year. Applying the Fisher Effect, they would agree to a nominal interest rate of 5 percent based on the accounting expression above. (5.00 = 3.00 + 2.00)
Even though it is difficult to determine the actual real interest rate today, we can determine what it was in the past. Let us plug in what we know. If the Fed Funds Rate is between 0 and 0.25 percent, then that is a proxy for the nominal interest rate. Between 4th quarter of 2007 and the beginning of the 4th quarter of 2010, the average inflation rate is at 1.6 percent. Therefore, applying the Fisher Effect, we must assume that the real interest rate must be around -1.35 percent. (0.25 = -1.35 + 1.60)
The negative real interest rate is consistent with the economic decline that we experienced during 2008-2010. However from the 4th quarter of 2010 and the end of 2013, we experienced an uptick of 2.2 percent in real gross domestic product. That means the real interest rate should be on the rise. Since the nominal interest rate remains near zero due to the Fed Funds Rate unchanged, then that would place downward pressure on inflation. For example, let us assume that the real interest rate increased from -1.35 percent to -0.75 percent, then that would mean the inflation rate would have to fall from 1.6 percent to 1 percent if the nominal interest rate is at 0.25 percent. (0.25 = -0.75 + 1.00)
Now knowing what we learned above, Cooke and Gavin describes three possible scenarios that will all be driven by the Fed’s credibility with investors.
Scenario 1: Investors lose credibility and believe inflation will rise significantly. That would lead to a similar environment of the 1970s where stagflation was the norm. This is certainly a scenario that we want to avoid.
Scenario 2: Investors still believe the Fed is credible and inflation remains around 2 percent. This scenario will allow the Fed to gradual raise interest rates without threatening a recovery. An increase in nominal interest rates will allow for the real interest rate to rise above zero. This is the best-case scenario.
Scenario 3: The Fed continues to keep interest rates low in an environment where the economy remains sluggish. In this case, nominal interest rates remain near zero and the real interest rate stays negative. This will cause investors to believe future inflation will fall. This is the worst-case scenario because deflation is tougher to reverse than inflation. With businesses forced to lower prices, that will lead to cuts in business spending and result in job losses.
Given the uncertainty caused by turmoil in the Middle East and Eastern Europe, do not be surprised if deflation becomes our biggest threat to a more robust recovery. Regardless, investors and their take on Fed credibility will be essential to determining our economic fate.