Target the spread?

To send you off with some more Thanksgiving good cheer, here is another out of the box Neo-Fisherian idea.

Perhaps the Fed (or the Treasury) should target the spread between real and nominal interest rates.

Above, I plotted the real (TIPS) and nominal 5 year rates. By the usual relationship \[ i_t = r_t + E_t \left[ \pi_{t+1} \right] \] we typically interpret the difference between real (r) and nominal (i) rate as the expected inflation rate.

Now, the usual Neo-Fisherian idea says, peg the nominal rate (i), eventually the real rate (r) will settle down, and inflation will follow the nominal rate. It's contentious, among other reasons, because we're not quite sure how long it takes the real rate to settle down, and there is some fear that real rate movements induce a temporarily opposite move in inflation.

So why not target the spread? The Fed or Treasury could easily say that the yield difference between TIPS and Treasuries shall be 2%. (I prefer 0, but the level of the target is not the point.)  Bring us your Treasuries, say, and we will give you back 1.02 equivalent TIPS. Give us your TIPS, and we will give you back 0.98 Treasuries. (I'm simplifying, but you get the idea.) They could equivalently simply intervene in each market until market prices go where they want. Or offer nominal-for-indexed swaps at a fixed rate.

Now, I think, the Neo-Fisherian logic is even tighter. If the government targets the difference \( i_t - r_t  \), in a firmly committed way, \( E_t \left[ \pi_{t+1} \right] \) is going to have to adjust.  I plotted 5 years, because I'm attracted to the idea of nailing down 5 year inflation expectations, but the general idea works across the maturity spectrum.

They might have to buy and sell a lot, you say? Indeed.  $4 trillion is a lot already, and Japan is embarked on even larger QE.   This might have fiscal consequences, you say? Indeed. That is, actually a lot of the point. Neo-Fisherian ideas are wrapped up with fiscal theory of the price level, and the spread peg is pretty much a fiscal commitment. It's a way of committing that we're going to inflate away the nominal debt at 2%, no more, no less. It's almost a modern gold standard in that way.  TIPS are illiquid, you say? Indeed. The contract structure could be improved a lot. But most of all, they'll be a lot more liquid when the Fed starts trading them every day!

What about the level of interest rates? That's the best part of the idea. If you're a free-money-market type, you could advocate that the Fed no longer target the level of either rate. If you're of the view that raising the level of interest rates is an important policy for the Fed to stabilize the real economy and induce short-run inflation movements (dynamics here), then the Fed can also move the level of short rates around, and at the same time target the spread.

The Fed has long used the TIP-Treasury spread to measure inflation expectations. But the same equation suggests the Fed (and Treasury) can directly control those expectations.

And, I hate to mention it, if a government wants to raise inflation expectations, firmly targeting such a spread would be a way to do it.