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July 31, 2004

A Hard Lesson for the Fed: New Tools for Managing Inflation in an Era of Price-Stability

By Kathryn M. Welling

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  • A Hard Lesson for the Fed: New Tools for Managing Inflation in an Era of Price-Stability
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Paul McCulley, Pimco's very own monetary maestro, has been flying around the globe lately, telling gatherings of central bankers to get with the new paradigm. And to get re-armed. In June, the Fed raised its target for the Federal Funds rate by one quarter of one percent. The war against secular inflation clearly has been won, Paul says, but this is no time for the monetary authorities to relax. -KMW

There's an ugly rumor going round that you recently gave a speech in Switzerland asking the Fed to lay more rules on the markets-What I am trying to do these days is be the first to lay out the parameters of this new world the Fed is operating in. They have to cyclically respond to inflation. But in the context of trying to win the peace of price stability, as opposed to the way they operated during the long war against inflation. I would like to have some sense of what policymakers' regularities are going to be.

Why should we have any better idea of their "regularities," as you say, in this brave new world than we had in the old?

No. 1 is that in a war against inflation, the central bank has to operate in a somewhat stealth fashion - because fighting inflation is a very anti-democratic thing to do.

Inducing a recession usually isn't a big vote-getter?

Democracy is founded on the notion of one person, one vote and ergo must be inflation-prone. The thing is, capitalism is inherently prone toward the opposite because of its cumulative voting system of one dollar, one vote. Fighting inflation involves having slack in men or machines, or as Marx said a long time ago, a reserve army of the unemployed. But it's very difficult for a central bank to say, "Your brother-in-law is unemployed because we have to fight a war against inflation."

Better you should think he is a lazy lout.

Exactly, because if they told you the truth, you'd have to contemplate letting him sleep in your rec room. The second reason that they need to be more transparent is that, with rates this low, almost any cyclical movements in interest rates become movements in real interest rates. So the Fed needs to manage expectations of where it is moving real interest rates. It was different during the war on inflation. We all knew there was someplace lower they wanted to go on inflation.

Okay. But suppose they get everybody used to candor - then have to go back to inflation-fighting?

Well, they are going into inflation-fighting mode now, but only on a cyclical basis. Winning the war against inflation doesn't mean that they won't have to occasionally lean against the cyclical winds of inflation. In a cyclical context, they have to lean against the wind in both directions. It is a very different paradigm.

Your position is that the Fed has to be more careful not to throw us back onto the road to "unwelcome disinflation?"