MNI: Wrong Look-Through Call Would Drain Fed Credibility-Paper
The Federal Reserve would be taking a major risk to its credibility if it decided to "look through" price changes seen as temporary because they were caused by supply change disruptions, especially with the memory of recent high inflation still fresh in the minds of Americans, according to research presented Saturday to the Federal Reserve's annual economic symposium in Jackson Hole.
Emi Nakamura, a professor at the University of California, Berkeley, told Fed and other central bank policymakers that central banks with strongly anchored inflation expectations and large amounts of inflation-fighting credibility are in general terms likely to be able to look through inflationary shocks. But even then attempting this inevitably costs central banks a significant amount of credibility in the short run.
"While the Fed and several other central banks with high credibility succeeded in implementing this strategy and achieving a soft-landing in 2022-2024, it is by no means obvious that this would work well a second time while the memory of the post-Covid inflation is fresh in the minds of consumers, firms, and financial markets," she wrote, along with coauthors Venance Riblier and Jon Steinsson of UC Berkeley.
"Central banks with a high degree of credibility have earned the right to venture beyond the Taylor rule," the paper said. But even a central bank with a high degree of inflation-fighting credibility can only attempt to look through non-oil inflationary supply shocks at a modest frequency. (See: MNI INTERVIEW: Fed Should Hold, Focus On Inflation - Emmons)
CREDIBILITY
In the aftermath of Covid, a particularly large deviation opened up between the Taylor rule and the federal funds rate. The maximum deviation was 1,125 basis points in early 2022, which is by far the largest Taylor rule deviation in the paper's sample since 1964. This large deviation closed as rapidly as it had opened up as the Fed raised rates and inflation fell over the course of 2022 and 2023.
If inflation expectations are imperfectly anchored, the paper says, then looking through a supply shock risks destabilizing inflation expectations which then sparks the beginnings of an inflation spiral that will eventually require very high interest rates to tame.
Today, core inflation is running nearing 3% and the unemployment rate at 4.2% is near what officials think is the non-accelerating inflation rate of unemployment, but growth is seen to slow as inflation looks likely to increase as the Trump administration's tariff policies feed into prices, even if temporarily.
The Fed’s inflation-fighting credibility -- built over 40 years before Covid -- allowed for a wider array of policy actions in fighting inflation during the Covid episode than were possible when the Taylor rule was originally proposed, the paper said. (See: MNI INTERVIEW: Fed September Cut Not Assured - Rosengren)
"But the Fed’s credibility is not infinite and could become severely depleted in the event of another bout of high inflation."
