Sunday, April 14, 2013

Operationalizing the Dual Mandate

In January 2012, the Federal open Market Committee put out a principles statement describing its longer-run goals and policy strategy. On April 13, Narayana Kocherlakota, President Federal Reserve Bank of Minneapolis, gave a speech on the "operational implications" of the principles statement. He focused in particular on paragraph 5 of the statement, which says the following:
The Committee seeks to mitigate deviations of inflation from its longer-run goal and deviations of employment from the Committee's assessments of its maximum level. These objectives are generally complementary. However, under circumstances in which the Committee judges that the objectives are not complementary, it follows a balanced approach in promoting them, taking into account the magnitude of the deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate.

If the Fed's only mandate were to mitigate deviations of inflation from its longer- run goal, Kocherlakota explains, then the Fed would aim for the green line, rather than the red line, in the graph below (from his slides.) He is confident that monetary policy works in one to two years, so reaching the inflation target of 2% (indicated by pi* in the graph) in two years would be both feasible and consistent with the mandate concerning inflation, if that were the only mandate.

Since the Fed has not one but two mandates, Kocherlakota explains, they must "balance" the inflation objective and the employment objective. He uses the graphs below to explain how he interprets "balance."

He says that the red line is "not balanced" because unemployment returns too slowly to its objective level u* (he does not specify its value.) The green line, on the other hand, he calls "balanced." It is more accomodative, with inflation rising faster and unemployment falling faster. The key point he makes is that inflation is allowed to rise temporarily above target, for a time, to help bring unemployment down.

A word I kept waiting for him to use is "symmetric." Last year, Mark Thoma noted that "the projections from members of the FOMC looked more like a ceiling than a central point," and thought that comments made by some officials could indicate that the Fed viewed the costs of overshooting and undershooting its target as asymmetric. If the objective were treated as a ceiling, then policymakers would choose the red line. Kocherlakota's  preference for the green line in the graph indicates that he does not view 2% as an upper bound on inflation, but is willing to allow inflation to go above 2%.

Thoma also wrote a fake interview with Kocherlakota in September asking him about the symmetry of the inflation target, and whether there is in fact an upper threshold on inflation. This fake interview was based on Kocherlakota's speech "Planning for Liftoff" in which he said that "as long as longer-term inflation expectations remain stable, the Committee will not raise the fed funds rate unless the medium-term outlook for the inflation rate exceeds a threshold value of 2 1/4 percent or the unemployment rate falls below a threshold value of 5.5 percent." There is no scale on the graph to tell us whether that green line, at its maximum, is "allowed" to go above 2.25%. 

Though the speech is called "Operational Implications of the FOMC's Principles Statement," I'm not entirely sure how those green lines are intended to be operationalized. Until somewhere around quarter 7 on his graph, the two mandates are actually complementary; accommodative policy brings both inflation and unemployment closer to target. Then it looks like accommodation continues until around quarter 10-- inflation keeps rising, unemployment falling. But what does the Fed do from quarter 10 onward to get inflation to fall and keep unemployment moving steadily downward? The reason the two objectives are sometimes called "not complementary" is because in previous experience it has been hard to achieve the kind of outcome he plots starting in quarter 10. So if I were fake-interviewing Kocherlakota, that is what I would ask him about.

In the graphs below, I replicated Kocherlakota's "Dual Mandate Outlook" graphs using data from the U.S. Survey of Professional Forecasters. The red lines show the mean forecasts for inflation and unemployment made in 2013Q1 for various time horizons. The dashed lines are pi* and u*, where for u* I used the forecasters' latest mean "natural rate of unemployment." The forecasters do expect something qualitatively similar to Kocherlakota's green "balanced" lines at first: they expect inflation to exceed the 2% target in sometime sooner than 8 quarters, and for unemployment to continue falling. But while Kocherlakota hopes inflation will peak in 10 quarters, the forecasters expect inflation to peak in 12 quarters (at 2.27%). And while he hopes inflation will fall back to target by around 16 quarters from now, the forecasters expect it to still be up at 2.24% even  in 20 quarters. 


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