How Martin Feldstein Learned to Stop Worrying and Love Inflation

Martin Feldstein and I go back a ways. Not that I have ever met him, which I haven’t, or that he has ever heard of me, which he probably hasn’t, but I have been following his mostly deplorable commentary on Fed policy since at least 2010 when he published an op-ed piece in the Financial Times, “QE2 is risky and should be limited,” which was sufficiently obtuse to provoke me to write a letter to the editor in response. A year and a half later, after I had started this blog – five years ago to the day on July 5, 2011 – Feldstein wrote an op-ed (“The Federal Reserve’s Policy Dead End”) in the Wall Street Journal, to which he is a regular contributor, in which he offered another misguided critique of quantitative easing, eliciting a blog post from me in response.

Well, now, almost six years after our first encounter, Feldstein has written another op-ed (“Where the Fed Will Be When the Next Downturn Comes“) for the Wall Street Journal which actually shows some glimmers of enlightenment on Feldstein’s part. Always eager to offer encouragement to slow learners, I am glad to be able to report that Feldstein seems to making some headway in understanding how monetary policy operates. He is still far from having mastered the material, but he does seem to be on the right track. If he keeps progressing, the Wall Street Journal will probably stop publishing his op-eds, which would be powerful evidence that he had progressed in understanding of the basics of monetary policy.

The Fed’s traditional response to an economic slump is to cut rates sharply in order to stimulate interest-sensitive spending. When the U.S. economy headed into recession at the end of 2007, the Fed cut the short-term federal-funds rate by three percentage points within 12 months. But it can’t do that anytime soon with short rates at less than 1%. And raising the federal-funds rate now to 3% or more would push the economy into recession.

Yet, whether by accident or intent, Fed policy is headed down a path that could eventually solve this problem. The Fed’s plan to continue a very easy monetary policy over the next few years is likely to drive the inflation rate to more than 3%. The Fed could then raise the federal-funds rate rapidly, reaching at least a 3% nominal rate, while still keeping a low or negative real fed-funds rate. This would put the Fed in a position to cut rates sharply when a new downturn occurred.

Bravo, Professor Feldstein! If only he had seen the light back in 2010 when he wrote the following in the Financial Times:

Under the label of QE, the Fed will buy long-term government bonds, perhaps one trillion dollars or more, adding an equal amount of cash to the economy and to banks’ excess reserves. Expectation of this has lowered long-term interest rates, depressed the dollar’s international value, bid up the price of commodities and farm land and raised share prices. . . .

Ahead, when the US economy does begin to grow, the increased cash on banks’ balance sheets will make the Fed’s exit strategy harder. It was previously “cautiously optimistic” it would be able to contain the inflationary pressures that could be unleashed by banks with a trillion dollars of excess reserves. This will be harder if the amount of excess reserves is doubled. This could lead to much higher interest rates to restrain demand or to an unwanted rise in inflation.

But now Feldstein is singing a different tune:

Based on the Fed’s own numbers, the real federal-funds rate will still be negative at the end of 2017. All of this is aimed at driving down the unemployment rate to only 4.6% in 2018, the median of the Federal Open Market Committee’s projections. Since that rate is less than the 4.8% rate Fed policy makers judge to be the long-term sustainable rate, their projections of unemployment imply that inflation will continue to rise beyond the Fed’s stated 2% target.

If the Fed succeeds in achieving this—raising the inflation rate above 3% and then raising the fed-funds rate close to that level without pushing the economy into recession—it will have solved the problem of having a high-enough fed-funds rate to deal with a traditional economic downturn.

Financial markets may of course get nervous if the Fed continues to have a very low interest rate even after it has achieved its dual goals of low unemployment and a 2% inflation rate. But the Fed could then argue that the 2% inflation rate was never intended as a ceiling but as an average rate to be achieved over time. Since annual inflation has been below 2% for more than three years, it would arguably be consistent with the Fed’s goal to have inflation temporarily above 2%.

So Professor Feldstein seems at last to have figured out that whether inflation is bad or “unwanted” depends not just on an arbitrary number, but on the overall economic environment. If real interest rates are very low or negative, as they are now, the optimal inflation target must be higher than when the real interest rate is above 3%.

But old habits are hard to break, and Feldstein is still nervous about 3% inflation, even in an environment like ours in which real interest rates are low and falling, as they have been doing for some time, even though measured inflation has turned up ever so slightly, largely reflecting a minor rebound in oil prices, since the first quarter of 2016.

Of course, this path of future inflation and interest rates may not be what the Fed has in mind. But it does look consistent with the Fed’s current actions and its projected plans for interest rates over the next two years. It would be a clever policy but it would also be a policy of high-risk fine-tuning.

It’s risky because the financial markets may not be convinced that the Fed will act to reverse an inflation rate that has drifted above 3% and continues to rise. That could cause long-term interest rates to rise sharply, leading to declines in the prices of equities and of commercial real estate. The resulting higher mortgage rates would depress house prices and housing demand. The higher long-term interest rates would also inflict large losses on bondholders who had bought long-term bonds with very low coupons. These financial losses could precipitate an economic downturn. Fed actions to cut its newly increased fed-funds rate might not be enough to reverse that downturn.

If Feldstein is worried that a temporary increase in the rate of inflation might unleash uncontrollable inflationary expectations, he ought to read up on price-level targeting (PLT) or on nominal gross domestic product level targeting (NGDPLT). When the policy target is the path of the price level or of NGDP, inflation expectations are sensitive not to the current rate of inflation but to where the price level is relative to its target path or where NGDP is relative to its target path. So when, under level targeting, inflation speeds up temporarily after having previously undershot its target path, there is no reason for the corrective temporary rise in inflation to cause inflation expectations to explode, as Feldstein fears they would. Feldstein should read up on level targeting before he writes his next op-ed. Although the Wall Street Journal might not be too happy with it, I am sure that, as a distinguished Harvard Professor, he will have no troubled getting it published somewhere else, maybe even in the Financial Times.


8 Responses to “How Martin Feldstein Learned to Stop Worrying and Love Inflation”

  1. 1 Indranil Chakraborty July 6, 2016 at 1:13 am

    David i learn a lot from reading your blogs but i find your patronizing tone towards Prof Feldstein a little sub par by your otherwise exacting standards of hitting the ideas and not the petson . Regards


  2. 2 JKH July 6, 2016 at 5:19 am

    “So when, under level targeting, inflation speeds up temporarily after having previously undershot its target path, there is no reason for the corrective temporary rise in inflation to cause inflation expectations to explode, as Feldstein fears they would.”

    I’m not sure about this.

    Suppose under inflation targeting that actual inflation undershoots a target of 2 per cent for a period of time. The central bank in response runs an “easy” policy in an attempt to steer inflation back to 2 per cent. Suppose it overshoots on easing such that inflation reaches 3 per cent. It then tightens, etc. etc. In fact, such a cycling of undershooting and overshooting is roughly the way it works in normal times when inflation targeting unambiguously above the zero bound. That is the essence of typical central bank policy interest rate cycles. Roughly speaking, every episode of tightening is an attempt to steer inflation back from a previous point of easing that has overshot the inflation target, and vice versa.

    Now consider level targeting. Suppose the level target is equivalent to a counterfactual constant inflation rate of 2 per cent. Suppose the central bank undershoots this target by 1 per cent for 3 years. So it eases. Suppose it gets back to level target after a further 3 years. At this point in time, for example, there is nothing to say that the actual inflation rate might not be 3 per cent – just as it might be in an overshooting easing response to prior undershooting of an inflation target.

    So why should the level regime make a difference to essential expectations in the sense of the ability of the central bank to bring the inflation rate back to target under inflation targeting versus its ability to stabilize the level at those points when the level target has been “hit” (i.e. when the actual inflation rate may well be inconsistent with subsequent level stabilization).


  3. 3 David Glasner July 6, 2016 at 12:20 pm

    Indranil, Thanks for your comment. I wrote this post quickly late last night, and if I had slept on it, I might have toned down the sarcasm, which was probably excessive. Actually, you may be giving me too much credit for sticking to the issues and not the person. I think that I have been at least as hard, if not harder, on John Taylor, the egregious Stephen Moore, Robert Barro, and Arthur Laffer in some of my posts, so I do get annoyed sometimes and let it show. But I will try to be a little kinder and gentler from now on.

    JKH, I think that the answer to your question is that level targeting makes the policy goal more explicit, so that there is less ambiguity in trying to figure out what is going in the period when inflation speeds up to compensate for an earlier slow-down. But you are right that the level target in and of itself does not guarantee that there could not be some cyclical movements above and below the target. A policy rule is not a panacea, but level targeting seems better than rate of change targeting.


  4. 4 aciddc July 6, 2016 at 2:59 pm

    It’s weird and scary how monetary policy controls our lives and somehow the people making it have no idea what they’re doing. It was forgivable a century ago, but now we have the theory pretty well worked out and the only remaining justifications for ignorance are laziness and ideological blinkers.


  5. 5 Benjamin Cole July 7, 2016 at 6:01 am

    Great post. And yes, Martin Feldstein and others are slowly, ever so slowly, releasing a grip on their security blankets and pondering a brighter world in which runaway inflation is not hiding under every bush.

    Actually, perhaps we should give Feldstein some credit. Other commentators, from the BIS for example, still scare-monger about inflation, but have toned that down to instead feature long-faced warnings about “financial instability” threatened by central bank low-interest rate policies and QE.

    Helicopter money is still a Satanic ritual beyond the pale, but maybe in time….

    BTW, check out Takahashi Korekiyo….


  6. 6 jonny bake July 7, 2016 at 12:45 pm

    How will inflation hit 3% if the Fed has an inflation ceiling of 2%?
    Feldstein misses the obvious.
    Absent an inflationary commodity shock, a 2% target can keep the economy mired in slow growth for decades.
    To get 3% inflation, the Fed would need to first revisit the 2% inflation target and come to the conclusion that it is too low and set the target above 3%

    That is not a conclusion the current Fed is likely to reach. They don’t view the 2% target as a mistake. They are still fighting the last war: 1970s inflation.


  7. 7 Tom Brown August 2, 2016 at 11:55 am

    If he keeps progressing, the Wall Street Journal will probably stop publishing his op-eds, which would be powerful evidence that he had progressed in understanding of the basics of monetary policy.

    I like the sarcasm. Keep writing posts quickly late at night! =)


  1. 1 News: Real Estate, Risk, Economics. Jul. 6, 2016 | PropertyPak Trackback on July 6, 2016 at 12:07 am

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About Me

David Glasner
Washington, DC

I am an economist in the Washington DC area. My research and writing has been mostly on monetary economics and policy and the history of economics. In my book Free Banking and Monetary Reform, I argued for a non-Monetarist non-Keynesian approach to monetary policy, based on a theory of a competitive supply of money. Over the years, I have become increasingly impressed by the similarities between my approach and that of R. G. Hawtrey and hope to bring Hawtrey’s unduly neglected contributions to the attention of a wider audience.

My new book Studies in the History of Monetary Theory: Controversies and Clarifications has been published by Palgrave Macmillan

Follow me on Twitter @david_glasner


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