Explicit inflation target is the talk of the day to stop deflation

With the CPI numbers just being released, the CPI MOM was down .7% in December and the YOY was up only .1%. The decline to current YOY levels is unprecedented. There were some steep falls in the past 30 years, but inflation was at much higher levels. Both the absolute and relative declines this month were significant. Much of the headline inflation decrease is associated with the decline in commodity prices; nevertheless, the core CPI is still hovering at 1.8% and is relatively sticky. The core has fallen below 2% for the first time in five years when it was just above 1%.

Economic policy circle discussions have been focused on deflation. With a strong recession, we could see negative inflation as prices are further revised downward. Low inflation is embedded in break-even spreads between nominal and TIPS bonds. Deflation is a major negative for borrowers and will only make the economic situation worse, so one of the keys to monetary policy will be to ensure that we inflate the economy. This has led to more discussion about setting firm inflation targets for the Fed.

More Fed presidents are coming out with the idea that an explicit inflation target should be the working policy of the Federal Reserve. This will send a clear signal on the target that will manage monetary policy and manage anxiety on deflation. The easing would stop if inflation moves above the target. More importantly, the problem of a zero bound will be stopped. If rates are close to zero, then any deflation will lead to positive real yields which will have a negative impact on the economy. Because long-term rates are so driven by inflationary expectations, an explicit target will reduce nominal uncertainty and allow rates to find a fixed range. The chance of wild deflation or inflationary expectations would be stopped.

Inflation targeting has been effective during the 1990’s to control inflation. Now central bankers want it to be used to control deflation. The problem is determining how to structure these targets. Do you use core or headline inflation? How low does inflation have to go before the Fed will act to further add money to the system? What will happen if inflation starts to increase above the target yet the recovery is only beginning? What will happen to Fed communication and creditability if they do not hit the target? While there has to be new innovative targets for measuring policy during a deflation, care has to be taken in forming the structure of a new policy or the market will face greater uncertainty