Beware the Monetary Cliff

November 12, 2013

Unlike the U.S. fiscal cliff, which was largely defused by congressional action, the U.S. monetary cliff -- which will be reached if U.S. inflation rates turn negative -- cannot be easily circumvented. Because the United States is the largest economy in the world, U.S. deflation would be exported to the rest of the world, says John H. Makin, a resident scholar at the American Enterprise Institute.

The Fed, under Chairman Bernanke and soon-to-be chairman Yellen, can do three things to reduce the risk of going over the deflationary monetary cliff.

First, the Fed should temper its complacency about the possibility of further disinflation and deflation.

  • If disinflation persists and the Fed's favorite inflation measure, the core personal consumption expenditures, drops below 1.0 percent (it is currently at 1.2 percent), then the Fed should restate the desirability of boosting inflation and underscore efforts to achieve that goal.
  • Perhaps signaling a possible increase in quantitative easing rather than another hint of tapering will be required.

Second, the Fed could underscore its desire to avoid deflation by setting a new target range for inflation with a firmly defined lower bound.

  • Currently, the Fed talks about a 2 percent inflation target, with any significant rise above that level leading to Fed tightening. The Fed would do well to reinforce the symmetry of its goal with respect to the behavior of inflation.
  • The Fed could highlight its long-run commitment to avoid inflation, along with its desire to avoid deflation, by specifying a target range of around 0.5 percent to 1.5 percent for inflation.

Yellen's elevation to the chairmanship of the Fed, probably during the first quarter of next year, presents the Fed's third opportunity to underscore its commitment to avoid deflation. By discussing the risk of deflation at some length and by putting a firm floor on the Fed's willingness to tolerate a drift toward deflation, Yellen could substantially reduce the risks that fears of deflation could produce.

Avoiding a self-reinforcing deflationary spiral should be a clearly articulated objective of the Yellen Fed.

Source: John H. Makin, "Beware the Monetary Cliff," American Enterprise Institute, October 28, 2013.

 

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