“Low rates for longer” means that risky assets (equities, corporate bonds, real estate) would reach higher valuation levels under the belief that monetary policy would remain expansionary as long as the cumulative inflation shortfall hasn’t been corrected. One can imagine how markets would react when the price level gap is about to be closed (around T2 in the chart) considering this would fuel expectations of an accelerated policy normalisation, i.e. tightening. Years of quantitative easing have raised concerns about financial stability risks. Prolonged inflation overshooting to correct for the past inflation shortfall could make things even more challenging.
Considering that, in the case of inflation targeting, a persistent undershoot of the 2% inflation target could cause inflation expectations to drift lower, thereby reducing the ability of monetary policy to stimulate activity because nominal interest rates would structurally be lower, Federal Reserve Bank of New York CEO and President, John Williams, has recently said being pleased that the Fed is undertaking a review of its policy framework[5]. Interestingly, he also showed that the cyclically sensitive components of the price index had behaved normally in the current expansion. These components are less subject to measurement errors and non-cyclical factors such as supply shocks, globalisation and changing market structure. This raises an important question however: if one accepts that cyclically sensitive inflation is behaving normally, this would mean that the inertia in overall inflation, despite the disappearance of slack, essentially reflects the role of supply factors. In this case, should monetary policy strive to compensate for these supply factors? Would it be able? Would this entail an overshooting of cyclically sensitive inflation? These questions illustrate the complexity of conducting a monetary policy based on inflation targeting when changes on the supply side have altered the price dynamics in certain sectors, in particular the goods producing ones.
Notwithstanding the questions raised by inflation versus price level targeting, the comprehensive review of strategies, tools and communications practices should be welcomed, if only because it shows that the Federal Reserve wants to be ready when the next recession hits and to be in a position, if necessary and warranted, to adapt its strategy and toolkit. The discussion is interesting from a eurozone perspective as well. After all, the Fed and the ECB share many challenges (low rates, a large balance sheet, inflation undershooting). As European rates are lower, the challenge facing the ECB looks even bigger. It is interesting that the Fed, which has a symmetric objective (implying that it would accept some inflation overshooting), is about to start a reflection on whether it should commit to prolonged overshooting to make up for past inflation misses. The conclusions should be followed in Frankfurt with great interest, all the more so considering that the ECB has an asymmetric inflation objective and hence is reluctant to accept a temporary overshooting.
