Must the FOMC increase its target before inflation, or will inflation increase and cause the FOMC to increase its target?Inflation (Finance) ; Federal funds rate ; Federal Open Market Committee

Daniel L. Thornton

English

Research Papers in Economics

Economic SYNOPSES
short essays and reports on the economic issues of the day
2010 ■ Number 25
T
he president of the Federal Reserve Bank of
Minneapolis, Narayana Kocherlakota (2010), noted
recently that monetary neutrality “implies that if
the FOMC [Federal Open Market Committee] maintains
the fed funds rate at its current level of 0-25 basis points
for too long, both anticipated and actual inflation have to
become negative.” Using a different theoretical framework,
James Bullard (2010), president of the Federal Reserve Bank
of St. Louis, also noted recently that policymakers must be
wary of falling into a deflationary trap. For Kocherlakota,
the issue arises from the FOMC’s statement:
The Committee will maintain the target range for the
federal funds rate at 0 to 1/4 percent and continues to
anticipate that economic conditions, including low rates
of resource utilization, subdued inflation trends, and stable
inflation expectations, are likely to warrant exceptionally
low levels of the federal funds rate for an extended period
(emphasis added).1
This statement seems to imply that the FOMC will keep
the target funds rate near zero until (i) economic activity
increases significantly or (ii) inflation begins to accelerate
significantly. Kocherlakota notes that “long-run monetary
neutrality is…uncontroversial.” Monetary neutrality implies
that monetary policy can have no permanent effects on the
real economy—for example, economic growth, the unem-
ployment rate, and the real rate of interest. Economic growth
and the real interest rate are determined by economic fun-
damentals that are not affected by monetary policy in the
long run. This fact, coupled with the fact that the nominal
interest rate is equal to the real interest rate plus expected
inflation, implies that if the FOMC keeps the nominal funds
rate near zero for an extended period, the long-run equilib-
rium rate of inflation consistent with a near-zero nominal
funds rate must be negative.
This scenario raises an interesting question: Must the
FOMC’s funds rate target increase before inflation, or will
inflation increase and cause the FOMC to increase its nomi-
nal funds rate target? Conventional thinking about mone-
tary policy suggests that policymakers should keep the
overnight federal funds rate low because the low nominal
rate necessarily translates into low real rates in the short
run (i.e., as long as the inflation rate remains positive). For
example, the 1-year Treasury rate averaged 30 basis points
in July 2010, while the consumer price index inflation rate
for the year ending in July was 1.31 percent. This means
that anyone purchasing a 1-year Treasury security can expect
to earn a negative return of about 1 percent if the inflation
rate over the next year is the same as during the previous
year. Of course, if the inflation rate should decrease, the
actual real return would be higher.
The motivation for keeping real interest rates low is
simply that low real interest rates are thought to stimulate
aggregate demand, which will increase economic output.
As the economy recovers and inflation picks up, the FOMC
will adjust its interest rate target to a level that is consistent
with both a positive equilibrium real interest rate—deter-
mined by economic fundamentals—and a rate of inflation
consistent with the FOMC’s objective of price stability.
Kocherlakota suggests that while this approach sounds
simple, it isn’t. Specifically, he notes, “When real returns are
normalized, inflationary expectations could well be nega-
tive, and there may still be a considerable amount of struc-
tural unemployment.” In such a circumstance, Kocherlakota
raises the concern that the FOMC “might be inclined to
keep its target rate low. That kind of reaction would simply
re-enforce the deflationary expectations and lead to many
years of deflation.”
Which Comes First: Inflation or the FOMC’s
Funds Rate Target?
Daniel L. Thornton, Vice President and Economic Adviser
Must the FOMC increase its target
before inflation, or will inflation
increase and cause the FOMC 
to increase its target?Kocherlakota considers this scenario “highly unlikely”;
however, it can be easily avoided if the FOMC begins now
to adjust its funds rate target up to a level more in line
with economic fundamentals consistent with a positive
real interest rate and with the FOMC’s implicit inflation
objective. Most economists believe that the long-run equi-
librium real interest rate is in the neighborhood of 2 to 3
percent; however, the real rate may be somewhat lower dur-
ing periods of economic slack (say, 1 percent). Also, most
analysts believe that the FOMC’s implicit inflation objective
is about 2 percent. These numbers suggest that the funds
rate target consistent with economic fundamentals and the
FOMC’s objective for price stability is somewhere in the
range of 3 to 5 percent. This means that the FOMC could
increase its target for the funds rate to about 2 percent and
still have a very accommodative monetary policy.
While neither Kocherlakota nor Bullard suggest such
a change in policy, one voting member of the FOMC,
Thomas Hoenig (2010), president of the Federal Reserve
Bank of Kansas City, has suggested that the FOMC should
slowly increase the funds rate target to 1 percent and then
assess the economic and financial conditions to determine
whether further adjustments are warranted. The Bank of
Canada appears to be following this procedure. Since reduc-
ing its overnight rate target to 25 basis points on April 21,
2009, the Bank of Canada has increased the target 25 basis
points at its past three policy meetings.2
Such a policy offers several advantages, including virtu-
ally eliminating the possibility of the deflationary scenario
that worries Kocherlakota and Bullard. If the policy is pre-
sented in the context of Kocherlakota’s analysis—that it is
simply an adjustment to keep the target funds rate more in
line with economic fundamentals consistent with a positive
real rate and price stability—it could prevent a further ero-
sion of inflation expectations, which have declined in recent
months.3 It would also make it considerably easier for the
Fed to return to normal monetary policy operations when
the economy fully recovers.4
Importantly, such a change in policy would likely have
a minimal effect on the effectiveness of monetary policy
for promoting a sustained economic recovery. A funds rate
target of 1 or 2 percent is still very low relative to the rate
consistent with the long-run equilibrium real rate, and the
FOMC’s implied inflation objective. Hence, monetary policy
would remain accommodative.
Furthermore, monetary policy has already been effective
in improving economic activity: It is extremely likely that
real gross domestic product will be at or above its pre-
recession peak level in the third quarter of 2010, and most
forecasters expect economic growth at or near potential
in 2011, even though growth is now expected to be slower
than previously forecast for the remainder of the year. As
Kocherlakota conjectured, employment growth could
remain sluggish for some time and the unemployment
rate uncomfortably high even as output grows at or near
potential, but there is little that monetary policymakers can
do to increase employment apart from promoting economic
growth. Monetary policy alone cannot correct the disloca-
tions in the labor market that resulted from the severe con-
tractions in residential and commercial real estate and the
recession more generally. ■
References
Bullard, James. “Seven Faces of ‘The Peril.’” Federal Reserve Bank of St. Louis
Review, September/October 2010, 92(5), pp. 339-52;
http://research.stlouisfed.org/publications/review/10/09/Bullard.pdf.
Hoenig, Thomas M. “The High Cost of Exceptionally Low Rates.” Speech at the
Bartlesville Federal Reserve Forum, hosted by Bartlesville Chamber of Commerce,
Bartlesville, Oklahoma, June 3, 2010;
www.kansascityfed.org/SpeechBio/HoenigPDF/Bartlesville.06.03.10.pdf. 
Kocherlakota, Narayana. “Inside the FOMC.” Speech in Marquette Michigan, on
August 17, 2010;
www.minneapolisfed.org/news_events/pres/kocherlakota_speech_08172010.pdf.
Thornton, Daniel L. “The Lower and Upper Bounds of the Federal Open Market
Committee’s Long-Run Inflation Objective.” Federal Reserve Bank of St. Louis
Review, May/June 2007, 89(3), pp. 183-93; 
http://research.stlouisfed.org/publications/review/07/05/Thornton.pdf.
Thornton, Daniel L. “The Unusual Behavior of the Federal Funds Rate and
Treasury Yields: A Conundrum or an Instance of Goodhart’s Law?” Working
Paper No. 2007-039D, Federal Reserve Bank of St. Louis, revised August 2010;
http://research.stlouisfed.org/wp/2007/2007-039.pdf.
1 Board of Governors of the Federal Reserve System. FOMC press release,
August 10, 2010; 
www.federalreserve.gov/newsevents/press/monetary/20100810a.htm.
2 The economic fundamentals in the United States and Canada are somewhat
similar. For example, real gross domestic product growth over the past four quar-
ters was 3.2 percent for the United States and 3.4 percent for Canada, and both
countries experienced a significant slowing of output growth in the second quarter
this year. The U.S. unemployment rate has declined 0.6 percent, compared with
0.8 percent for Canada. The Canadian unemployment rate is much lower, how-
ever (7.9 percent compared with 9.5 percent in the United States); and Canada’s
employment growth during the first half of 2010 was faster (3.7 percent compared
with 2.1 percent for the United States).
3 See Thornton (2007) for a specific example of the effects of the FOMC’s policy
statements on inflation expectations.
4 Critics of this approach argue that if inflation expectations do not adjust, ex post,
real interest rates would rise or the increase in the funds rate would increase
longer-term rates, which could have a contractionary effect on prices—which,
in turn, could reduce rather than increase inflation expectations. See Thornton
(2007) for an discussion of why the effect on long-term rates is likely to be
negligible.
Economic SYNOPSES Federal Reserve Bank of St. Louis      2
research.stlouisfed.org
Posted on September 14, 2010
Views expressed do not necessarily reflect official positions of the Federal Reserve System.

1 Board of Governors of the Federal Reserve System. FOMC press release,

Federal Reserve Bank of St.

for a specific example of the effects of the FOMC’s policy statements on inflation expectations.

Inside the FOMC.” Speech in

Seven Faces of ‘The Peril.’” Federal Reserve Bank of St. Louis Review, September/October

The High Cost of Exceptionally Low Rates.” Speech at the Bartlesville Federal Reserve Forum, hosted by Bartlesville Chamber of Commerce,

The Lower and Upper Bounds of the Federal Open Market Committee’s Long-Run Inflation Objective.” Federal Reserve Bank of St. Louis Review,

The Unusual Behavior of the Federal Funds Rate and Treasury Yields: A Conundrum or an Instance of Goodhart’s Law?” Working Paper No. 2007-039D, Federal Reserve Bank of St. Louis, revised

Which comes first: inflation or the FOMC's funds rate target?

http://research.stlouisfed.org/publications/es/10/ES1025.pdf

Which comes first: inflation or the FOMC's funds rate target?

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