Fed’s Brainard: Inflation Expectations Could Complicate Our Task

14 July, 2020

By David Barwick – FRANKFURT (EconoStream) – The possibility of inflation expectations becoming unanchored could make it harder to chart a monetary policy course through the current crisis, Lael Brainard, member of the U.S. Federal Reserve's Board of Governors, said Tuesday.

Speaking via webcast for the Perspectives on the Pandemic Webinar Series hosted by the National Association for Business Economics, Brainard, according to a text provided by the Fed, indicated support for temporarily exceeding the Fed’s 2% inflation objective and for considering adding targets on the short-to-medium end of the yield curve.

Although measures of inflation expectations have not uniformly shown deterioration, she said, given many years of below-target outcomes, ‘the risk that inflation expectations could drift lower complicates the task of monetary policy.’

Monetary policy needs to be guided by the demands of the crisis, but also by insights of longer-run nature ‘so as to avoid the premature withdrawal of necessary support’, she said. The historically low level of the underlying real interest rate at which saving and investment are in equilibrium implies less room for rate cuts, she said, but a policy rate persistently at the lower bound could erode actual and expected inflation, generating a ‘downward spiral’ of ever less room to maneuver.

‘With underlying inflation running below 2% for many years and COVID contributing to a further decline, it is important that monetary policy support inflation expectations that are consistent with inflation centred on 2% over time’, she said. ‘[P]olicy should not preemptively withdraw support based on a historically steeper Phillips curve that is not currently in evidence’, but should instead ‘seek to achieve employment outcomes with the kind of breadth and depth that were only achieved late in the previous recovery.’

Brainard called forward guidance in the current environment ‘a vital way to provide the necessary accommodation.’ Deferring liftoff until inflation has hit 2% ‘could lead to some modest temporary overshooting, which would help offset the previous underperformance’, she said. Moreover, balance sheet policies can reinforce an accommodative stance ‘by more directly influencing the interest rates that are relevant for household and business borrowing and investment.’

Although it would probably require appropriate previous deliberation, she said, ‘there may come a time when it is helpful to reinforce the credibility of forward guidance and lessen the burden on the balance sheet with the addition of targets on the short-to-medium end of the yield curve.’

Turning to the economic outlook, Brainard said that ‘[w]ith a dense fog of COVID-related uncertainty shrouding the outlook, the recovery likely will face headwinds for some time, calling for a sustained commitment to accommodation, along with additional fiscal support.’

Despite vigorous rebounds in employment and output in May and June, risks are tilted to the downside, she said, and there are early signs that the job market recovery decelerated after the first half of June.

In any case, economic headwinds are likely even if the risks fail to materialize, she said, citing diminished activity in some sectors of the economy; the need for some sectors to adapt to altered circumstances; reduced personal income and corporate revenues; and the possibility of a new round of stringent social distancing if the public health situation deteriorates.

Financial market volatility could return, putting nonbank financial institutions under pressure and leading to reduced lending activity, she said.

‘In downside scenarios, there could be some persistent damage to the productive capacity of the economy from the loss of valuable employment relationships, depressed investment, and the destruction of intangible business capital’, she said. ‘A wave of insolvencies is possible.’