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Fed is facing tough sales on the inflation framework



PALO ALTO, Calif. (Reuters) – Federal Reserve makers fear they are poorly equipped to fight the next recession during their current inflation targeting, and this year is well under way to leverage new interest rate management strategies in a world of subdued inflation and low borrowing costs.

FILE PHOTO: The Federal Reserve building is depicted in Washington, DC, USA August 22, 2018. REUTERS / Chris Wattie / File Photo

But for US central bankers and monetary experts who converged in Palo Alto Friday To Discuss Available Alternatives were the challenge clear: not only will it be difficult to settle for a better framework before the next recession, find out how to explain it to the public so that it actually works will be a major challenge.

Just to explain their ideas to each other, Fed decision makers and academics at the Hoover Institute's annual conference showed the slide after the slide along with equations, long dots and almost undeveloped charts.

And while most doctoral economists in the audience probably understood the theories, "do I think where people disagree, do the models' assumptions really look like real life?" Cleveland Fed Bank President Loretta Mester said in an interview on the sidelines of the conference.

In other words, what will really work?

When central bankers around the world reached for unconventional tools such as bond purchases and forward guidance to combat the financial crisis 2007-2009, they believed they met once in a lifetime.

But a decade at the end of the big recession, it is clear that the Fed has a new economic norm. Without inflation or the interest rate is expected to rise much, even with US unemployment for almost 50 years.

It gives the central bank much less leeway to cut interest rates to stimulate the economy than it has historically had.

So this year, with the US economy on a steady keel, pausing interest rates, and an expansion set to reach record highs this summer, Fed makers find they have some breathing space to figure out how to do politics more effective when the next decline or shock comes together.

Among the Ideas: Commit to Excessive Inflationary Pressures with Periods of Over-Inflation; rely on simple political rules to take guesswork out of speed decisions; and use negative interest rates to force companies to invest and banks should borrow during recessions.

SHOCK ABSORBERS FOR A NEW WORLD

Everyone would, their lawyers say, act as shock absorbers to redeem financial weakness and shorten setbacks.

Each of them will deviate to a greater or lesser extent from the Fed's current approach, aiming at 2 percent inflation and a loosely defined ideal for full employment.

And everyone will depend critically on households, businesses and financial markets who understand the framework and respond accordingly.

Average inflation targeting is the frame selection that has so far attracted the most support. The idea that New York Fed President John Williams explained is that inflation should average 2 percent over a given period – say one and a half years.

When inflation falls in periods of economic stress, the central bank will respond by keeping simple policies in place until inflation rises above 2 percent and remains there for some time.

If households and businesses know they can rely on higher inflation in the future, they will borrow and spend more during the recessions, which will theoretically increase the return of the economy to health. But for the plan to work, providers must believe that the Fed will really drive inflation higher in the future.

Negative prices will stimulate the economy by punishing businesses for not spending money on the economy; If they only keep their money on the bank, they will end up paying for the privilege. However, for such a regime to be accepted, ordinary people would be sure they would not be punished.

Policy rules increase Fed credibility by posting a clear path for pricing based on the economy, said Cleveland Fed's Master. But if these rules are used too rigidly, they will not deliver the outcome Fed wants.

Not everyone at the conference was sold on the benefits of a new framework, not even the Fed makers who presented some of the ideas.

"The bar for change is high," said San Dalvad, then Mary Daly. "Making mistakes in this room can be costly."

St. Louis Fed chief James Bullard continued: experiment with the way the world's largest central bank does business "would free up chaos" in global financial markets.

Nevertheless, the group was keen to explore new ideas, and the Fed has half a dozen more incidents around the Framework planned for the rest of the year.

Most audiences gave the Fed credit to tackle the problem. Said Dartmouth College Economics Professor Andy Levin, "The Fed needs to find something new."

Reporting by Ann Saphir and Howard Schneider; Editing by Andrea Ricci

Our Standards: Thomson Reuters Trust Principles.

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