What is the Fed to do?
The Fed is supposed to cut real interest rates as the economy weakens, but the opposite seems to be happening. The problem is that the Fed is close to its zero lower bound on the federal funds rate, perceptions of credit risk are rising, and expected inflation is falling. Indeed, as I pointed out yesterday, people are increasingly concerned about possible deflation.
What is the Fed to do (other than pray)? Expectations management is the key.
Here is one idea. Suppose the Fed cuts the federal funds rate once again to, say, 25 basis points. More important, at the same time, the Fed announces a target path for the price level as measured by the core CPI. The price path might be, say, an increase of 2 or 3 percent per year. The Fed promises not to raise the fed funds rate over the next 12 months and, after that, will keep the funds rate at that low level as long as the price level is significantly below its target path.
The credibility of the promise is paramount. To get long-term real interest rates down, the Fed needs to convince markets that it will vigorously combat deflation, and that if deflation happens in the short run, the Fed will reverse it by subsequently producing extra inflation. A credible promise of subsequent price reversal after any deflation ensures that long-term expected inflation stays close to the inflation rate implied by the Fed's target price path. Monetary economists will recognize that this policy is price-level targeting rather than inflation targeting.
Would such an announcement by the Fed have the credibility it needs to work? Would such a monetary policy be enough to avoid a deep downturn? I am not sure. That's where the prayer part comes in.