Fed’s Dudley backs review of 2% inflation target

The Federal Reserve should review its inflation target as part of an assessment of its tools for fighting the next recession, one of the most influential US policymakers said, adding new impetus to an issue that Janet Yellen has said is among the most important questions facing monetary policy.

Bill Dudley, the president of the Federal Reserve Bank of New York, said it would be “prudent monetary policymaking” to put the central bank’s method of managing the economy on the agenda this year, even as he insisted this was not because he was worried the US faced the threat of an imminent downturn.

Economists have been fretting that central banks and finance ministries may find themselves with insufficient weapons in their armouries to fight the next downturn when it comes.

Ben Bernanke, the former Fed chairman, is among the senior figures who have said the US central bank should revisit its 2 per cent inflation target, which it adopted at his instigation in 2012. The target may prevent the Fed from raising interest rates very far during the current expansion, and leave it with little capacity to cut borrowing costs if another recession strikes.

Markets are watching for Jay Powell’s approach when he takes over from Ms Yellen as Fed chair in February. Within the Federal Reserve system a number of presidents have already spoken in favour of a review, including John Williams of San Francisco and Eric Rosengren of Boston.

In an interview with the Financial Times, Mr Dudley gave an upbeat overview of the US economy, dismissing the notion that it could be torpedoed by a sharp reversal in the stock market and describing the current state of play on jobs and inflation as one of the most positive in 50 years. The risks that the US is in a low-inflation trap have receded, he said, with overheating now the greater concern as the Republicans’ trillion-dollar tax cuts add fuel to the economy.

Nevertheless, the New York Fed president made it clear that he was in favour of a review of the Fed’s recession-fighting tools, even if he was sceptical about some of the more radical suggestions being put forward.

The balance of risks [is] shifting away from inflation being too low, to the risk of the economy overheating

Any rethink should start with the question of how likely it is that policy will again fall to the so-called zero lower bound and then, if so, whether the Fed has enough instruments to manage the process, he said.

“I don’t want to overstate the degree of concern I have,” Mr Dudley said, pointing out that the Fed had only been stuck at near-zero rates once in the past 70 years. He said: “I don’t want to totally upend monetary policy because of concerns we might go back to the zero lower bound, because I would worry a little bit that I was fighting the last war.”

Some central bankers have mooted the idea of shifting to a so-called price level target, where the central bank would make up for past shortfalls in inflation by overshooting — and vice versa. Mr Dudley said this was worthy of consideration even if it raised a lot of complications.

Alternatively the Fed could consider moving to an inflation target range of 1.5 to 2.5 per cent, or adopt a soft version of price level targeting under which it targets 2 per cent inflation “over the medium to longer run”.

Mr Dudley ruled out one suggestion, which is to lift the inflation target to 4 per cent from 2 per cent. In theory this would lead to higher rates and more rate-cutting firepower, but the New York Fed chief said such a high target could fall foul of Congress’s requirement that the Fed pursues price stability.

While some argue the Fed will not be able to lift rates very far because of the weakness of the economy, Mr Dudley said it was wrong to jump to the conclusion that the so-called neutral rate, which neither pushes growth nor holds it back, is “depressed permanently”.

Investors talk of the inflation-adjusted neutral rate currently being stuck at zero, but Mr Dudley said it may be higher. “Right now we have buoyant financial conditions and fiscal stimulus. Of course that could mean that the neutral federal funds rate is higher now than it was without those two things in place,” he said.

Mr Dudley, who is due to retire this summer, stuck to Fed forecasts for three more rate rises this year. While the Fed could do fewer, it was possible that the “Fed’s tempo in terms of monetary policy tightening might need to increase” as wages and inflation accelerate. It was “not an unreasonable assumption” that the next quarter-point rate rise will come in March, he added.

“There have been a lot of signs that suggest that this risk that inflation is going to continue to undershoot 2 per cent sort of indefinitely is not going to actually play out in fact,” he said. The “balance of risks [is] shifting away from inflation being too low, to the risk of the economy overheating.”

The added stimulus from tax cuts was raising the risk in 2019 or 2020 that the economy overheats as rising inflation fails to stop at 2 per cent, 2.1 per cent or 2.2 per cent, he said. This would force the Fed to step on the brakes harder. Historically the ability of the Fed has a “poor” record for engineering a soft landing when the unemployment rate has gone too low, he said.

Recent inflation data have been firmer and inflation compensation in financial markets was ticking up in recent weeks. “There are lots of things that suggest that inflation is probably starting to drift up towards our 2 per cent objective,” he said.