Monetary Policy & Inflation | Rates
Paul Volcker, who was a chairman of the Fed in the ‘80s, as a believer in inflation control and under his watch fed rates rose to 22% in 1981 where they peaked. His strategy for low inflation worked, and has since remained the principle monetary policy tool: they have maintained an average inflation of 1.5% since 2010. Robert Barro, a Professor at Harvard, however, presents a curious puzzle in monetary policy impact today. Recent research demonstrates that Fed rate changes and QE see only a small and delayed response by inflation and yields…
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Paul Volcker, who was a chairman of the Fed in the ‘80s, as a believer in inflation control and under his watch fed rates rose to 22% in 1981 where they peaked. His strategy for low inflation worked, and has since remained the principle monetary policy tool: they have maintained an average inflation of 1.5% since 2010. Robert Barro, a Professor at Harvard, however, presents a curious puzzle in monetary policy impact today. Recent research demonstrates that Fed rate changes and QE see only a small and delayed response by inflation and yields. Data shows that a contractionary monetary shock raises yields on Treasuries but only over a 3-5 year horizon, peaking at 2 years with only a moderate inflation impact observed over the same delayed period. Data also shows a contradictory reaction in output growth prediction – a rate hike predicts output growth and vice versa. Barro warns that there is therefore a credible threat of extreme Fed responses if inflation was to swing sharply in either direction – simply because policy tools seem to have a subdued and slow impact otherwise.
Why does this matter? If central banks have to engage in more extreme monetary policy actions to generate inflation, we cannot rule out negative rates and wider asset purchase programmes (such as in equities) even by the Fed.
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