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Monetary Policy: The Federal Reserve Is Doing It Wrong...

That has to be the conclusion of anybody coming at the problem of monetary policy from any applied-math optimal-control perspective.

James Hamilton sends us to the Fed's forecasts of inflation:

Econbrowser Inflation expectations and the Fed

If the Fed's view is that the PCE-deflator unemployment rate should be 2.0%/year on average (and why the PCE deflator? Why not the GDP deflator? Investment-goods prices are prices too), then if the Fed had a single mandate its policies should be such as to get us to 2.0%/year inflation if not next year than the year after. But it is not until the "longer run" three and more years into the future that the Fed's expectation of inflation converges to 2.0%/year.

But the Fed does not have a single mandate: it has a dual mandate. And that dual mandate commands it to tolerate short-run inflation higher than it thinks is ideal when by doing so it can reduce excessively high unemployment.

James Hamilton:

Econbrowser: Inflation expectations and the Fed: Noteworthy among the information released by the U.S. Federal Reserve last week was a statement of the FOMC's longer run goals and policy strategy. A key section reads:

The inflation rate over the longer run is primarily determined by monetary policy, and hence the Committee has the ability to specify a longer-run goal for inflation. The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve's statutory mandate.

This represents an important step in the direction of an explicit inflation target, which some academic research suggests might help lead to greater financial stability. It's very useful to connect this statement of longer run goals with other details released last week on what the Fed is expecting over the next several years…. [T]he FOMC is saying that it would like inflation to be about 2% annually, but is expecting it only to be 1.4 to 2.0% over the next 3 years. Putting 2 and (less than) 2 together, the FOMC is telling us that, based on its price stability objective alone, the Fed is expecting inflation to be lower than it would like. In other words, even if the economy were at full employment, a little more stimulus would be called for. And of course, nobody thinks the U.S. is anywhere close to full employment. The Fed's forecast is for an unemployment rate between 7.4 and 8.1% for 2013….

But what's the Fed waiting for?… The Fed is not alone in thinking that inflation will be lower over the next few years than it was in 2011. For example, the median respondent to the Federal Reserve Bank of Philadelphia's Survey of Professional Forecasters is anticipating 1.6 to 1.8% annual headline PCE inflation for 2012…. [E]expected inflation as inferred from the gap between nominal and inflation-protected 5-year Treasury securities has been coming in below 2% since last summer….

[A] key element of the success of anything the Fed tries to do is that the market has to believe the Fed can and will carry out what it says…. Without credibility, the Fed is only a paper tiger. The more political opposition the Fed faces, the less it can actually accomplish.