Marvin Goodfriend made a telling contribution to the Shadow Open Markets Committee – the US equivalent to our Shadow Monetary Policy Committee. [h/t David Andolfatto for sharing that].
His remarks lead us to note that while the Fed has a history of successfully fighting surges in inflation, which ought to reassure financial market observers that such surges would be combatted in the future, it has no comparable history of fighting the threat of deflation. It follows that such threats are more likely to be self-fulfilling, in that they are more likely to dislodge expectations of future inflation downwards, and, since inflation is partly determined by expected inflation, inflation itself is more likely to fall.
Even absent worries about credibility, the zero bound to interest rates already imparts an asymmetry in the risks to future inflation that should tilt a cautious central bank towards looser policy in its vicinity. Worrying about whether people think you have the tools or the inclination to combat the zero bound and deflation amplifies this asymmetry further.
When Goodfriend worries about these things, we should take note. He was one of the pioneers in getting the profession to think through the economics of the zero bound, and the impotence of conventional monetary policy in the face of it [viz the 2000 JMCB conference volume on the topic].
This tilting of the monetary policy risks is stronger, the more you think current things are affected by expected future things, and the more forward-looking people are in the way they form these expectations. Curiously, in New Keynesian macro, the former mechanism is stronger the more sticky you think economic decisions like price-setting are. If you can costlessly recalibrate any economic decision from minute to minute, then there’s no need to forecast the future and act on those forecasts. Conversely, if, for example, you are going to be bound into a wage contract for a long time, you will try to guess what inflation is going to do and bargain so that you are compensated for the effects of that guessed-at inflation up front.
Goodfriend’s argument about deflation credibility has an interesting historical resonance too.
Reflecting on the early days of the fight against high inflation, with the transition from Burns to Volcker to Greenspan, Goodfriend was an eloquent defender of the Fed’s vigorously counter-inflationary policy in respect of the Fed’s mandate for price stability. Now we see the same principled concern for price stability applied faithfully and symmetrically to the novel circumstances facing the Fed today, and asking us to consider fighting deflation with the same vim.
I think he was right then and is right now.