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A simple rule of thumb that summarizes the Fed’s policy response over the past two decades recommends lowering the federal funds rate by 1.4 percentage points if inflation falls by 1 percentage point and by 1.8 percentage points if the unemployment rate rises by 1 percentage point. Either headline inflation or core inflation can be used with this rule to construct policy recommendations. Relative to a core inflation formulation, a policy rule using headline inflation would have called for a higher fed funds rate in 2005-2006 before the recession and in 2008 in the midst of a deepening recession. Currently, both formulations call for substantial monetary accommodation.
The Fed, in it’s October meeting (after Lehman had failed on Sept. 16th) lowered their target fed funds rate only 50 basis points to 1.50. That week (Dec. 6th-10th), the DJIA fell 18%, but it wasn’t until Oct. 29th that the Fed met hastily in an emergency meeting to cut rates…50 basis points, to 1.00. What metric could they have been watching that would suggest (in a historical sense) that inflation was the problem, and not deflation? It could only have been headline inflation!
Core inflation has closely tracked a median ever since the Fed concerned itself with keeping inflation low (and stable). But what you really have to ask yourself is; what good is having a target when you are able to move between whatever measure suits your inclination at the moment? There is, of course, a mechanism by which inflation in energy prices (and thus broad inputs) can translate into a higher trend in core inflation (60’s-80’s), but this hasn’t been the case for thirty years.
The key here is that monetary policy should not be engaged in inflation targeting. Inflation is a symptom of an underlying problem (AD or AS shock), for which the Fed can only react to AD. If the Fed concerns itself with reacting to AS shocks, then we end up where we were in late 2008, with plummeting NGDP. The Fed should target the variable that it has control over, and keep it growing at a stable long-run rate.
Update: Accidentally hit the “Publish” button instead of preview. In any case, the SF Fed’s forecast is that the rise in commodity prices is unsustainable given the level of depressed aggregate demand in much of the world economy. Here is the chart:
The SF Fed also predicts a persistent (and rather large) output gap through 2012! That is a monumental failure of monetary policy.