“Can the Federal Reserve best meet its statutory objectives with its existing monetary policy strategy, or should it consider strategies that aim to reverse past misses of the inflation objective?”
“Are the existing monetary policy tools adequate to achieve and maintain maximum employment and price stability, or should the toolkit be expanded? And, if so, how?”
These, of course, are the two questions, identified at the outset of the Fed’s Review of Its Monetary Policy Strategy, Tools, and Communication Practices by Powell and Clarida. They point in two directions. First, a revision in strategy that is focused on makeup strategies. Second, with respect to new tools, only one has been mentioned, for example, by Clarida and in the minutes: is interest rate caps.
Enter Governor Brainard:
I have offered some preliminary thoughts on how we could bolster inflation expectations by achieving inflation outcomes of 2 percent on average over time and when the policy is constrained by the ELB [effective lower bound], how we could combine forward guidance on the policy rate with caps on the short-to-medium segment of the yield curve to buffer the economy against adverse developments.
Her views may be “preliminary”, but they are comprehensive, setting out well-thought answers to the two questions above.
From the October Minutes to Brainard’s Speech
Recall that the October minutes were principally a discussion and analysis of the unconventional policies implemented during the post-financial crisis period. There were, however, a few nuggets related to potential revisions in strategy and new tools: caps on short-term Treasury rates which, to my surprise, had widespread support among participants at the October FOMC meeting; and outcome-based forward guidance with the inflation objective as the threshold for liftoff, also mentioned in the Minutes and a direction that I expected to emerge in some form from the Review. Nevertheless, such innovations are bold and challenging to communicate and implement.
The Challenges to Monetary Policy Today
Brainard motivates the need for revisions to the policy framework by identifying the new challenges to monetary policy that call for revisions to the policy framework. These have been emphasized by all participants, but she presents them very well.
First, trend inflation is below target…with inflation having fallen short of 2 percent for most of the past seven years, inflation expectations may have declined.
Second, the sensitivity of price inflation to resource utilization is very low.
Third, the long-run neutral rate of interest is very low.
In “The Crisis in Central Banking”, I argued that these developments–a flat Phillips curve that makes it hard to reach the inflation objective; inflation expectations that, as a result, become adaptive; and the lack of sufficient space to cut the policy rate–can create an insurmountable challenge to achieving the inflation objective.
Can’t do anything about the flat Phillips curve, but policies deemed more credible in raising inflation can better anchor inflation expectations, which, in turn, can contribute to achieving and maintaining the inflation objective. The reduced space for traditional rate policy means that the emphasis in the Review must be on policies that can be implemented at the ELB.
Monetary Policy Should Advance Two Goals
First, monetary policy should achieve average inflation outcomes of 2 percent over time to re-anchor inflation expectations at our target.
Second, we need to expand policy space to buffer the economy from adverse developments at the ELB.
So Brainard favors some form of makeup policy, a direction that has clearly gotten a lot of attention in the Review. But describing the second goal as expanding the ”policy space” is a misleading use of that term, usually reserved for increasing the space for traditional rates policy, for example, by raising the inflation objective (and hence the buffer between the nominal neutral fund’s rate and the ELB) or enacting negative policy rates, both of which were immediately taken off the table in the Review. The second goal is better described as communicating to the markets more effectively that rates will be lower for longer.
A Flexible Make-up Strategy
It may be helpful to specify that policy aims to achieve inflation outcomes that average 2 percent over time or over the cycle.
She immediately rejects “formal make-up rules”; presumably, price level and average inflation targeting rules that I have said from the start are off the table. Note the Committee has already taken nominal income targeting off the table because that strategy does not have an explicit inflation objective. With respect to average inflation targeting, she favors a more flexible approach. Her direction seems to have similarities to Lars Svensson’s flexible average inflation targeting (AIT) proposal which he offered in a talk at the Chicago Fed Listens to the conference, a paper that I found intriguing [“Monetary Policy Strategies for the Federal Reserve”] and which I commented on in “Toward a Flexible Average-Inflation Targeting Strategy.”
Svensson’s innovation is to narrow the “look-back” period that defines the inflation shortfalls that are to be offset. He interprets rigid, rules-based AIT as having an infinite look-back period, ensuring that inflation will, in fact, average 2% over time. But would also be very demanding, a challenge to make credible to the public, and challenging to implement. In his proposal, Svensson assumes, “for concreteness,” a make-up period of five years and that this period is updated each year. As a result, his proposal still allows letting bygones be bygones to some degree and, as a result, is less demanding and more credible, though it does not guarantee that inflation will average 2% over time.
Following five years when the public has observed inflation outcomes in the range of 1-1/2 to 2 percent, to avoid a decline in expectations, the Committee would target inflation outcomes in a range of, say, 2 to 2-1/2 percent for the subsequent five years to achieve inflation outcomes of 2 percent on average overall.
Her proposal differs only slightly from Svensson’s. Svensson proposes, for concreteness, a five-year period over which the shortfall is computed— a five-year look-back period–and an undefined rate at which the shortfall is made up, not a period over which it is to be made up. The look-back period and the rate of makeup are therefore flexible, to be set by the central bank. Brainard, in contrast, uses a five-year period for both the lookback and the make-up periods.
Caps on Short- to Medium-term Treasury Securities
Brainard also supports a new tool (at least for the Fed): caps on interest rates:
There may be advantages to an approach that caps interest rates on Treasury securities at the short-to-medium range of the maturity spectrum—yield curve caps.
This is, of course, a BOJ innovation, referred to as yield curve control. I interpret Brainard’s paper as a clear signal that the Committee is leaning toward caps on interest rates of Treasury securities, specifically in the short-to-medium range of the maturity spectrum. That should not be a surprise though after this direction was applauded by most participants at the October FOMC meeting. So, I have raised such rate caps to high
on my list of anticipated revisions to the scope of acceptable tools coming out of the Review; indeed, the only such revision I anticipate. Note also that this was suggested by Bernanke in his classic 2002 speech, “Deflation – making sure “it” doesn’t happen here.”
Outcome-based Forward Guidance with an Inflation Threshold
Next, Brainard suggests a way to make forward guidance more powerful than as practiced earlier.
To reinforce this commitment, the forward guidance on the policy rate could be implemented in tandem with yield curve caps.
She refers to forward guidance with thresholds for both employment (presumably an unemployment rate) and inflation. But I expect, in the end, there will only be a threshold for inflation, since achieving the inflation objective and maintaining anchored inflation expectations has been the most challenging problem of central banks in advanced economies. This is the outcome I most strongly expect to come out of the Review.
Combining Rate Caps with Asset Purchases
[Capping short to medium term rates] could be augmented with purchases of 10-year Treasury securities to provide further accommodation at the long end of the yield curve. Presumably, the requisite scale of such purchases—when combined with medium-term yield curve ceilings and forward guidance on the policy rate—would be relatively smaller than if the longer-term asset purchases were used alone.
I have seen yield curve caps and asset purchases as substitutes rather than complements, so this surprised me. One is about setting the quantity and letting markets determine the price; the other about setting the price and letting the market determine the quantity. Pick one or the other! But, as I thought about it, Brainard’s proposal made sense, and, there is a case that this would require a smaller scale of purchases than when asset purchases were used alone.
While asset purchases appear to remain on the table for use the next time at the ELB (given that participants judged them as having been effective and not subject to diminishing returns), I have thought the Committee might be reluctant to use asset purchases aggressively following the very large expansion of the balance sheet. However, Brainard makes a good case that any asset purchases would likely be smaller than otherwise if combined with the rest of the proposals, making using them more attractive once again.
Using both rate caps and asset purchases makes sense when one considers that long-term rates depend on both expectations of short-term rates over the maturity of the long-term security and on the term premium. Rate caps affect the former and asset purchases the latter. Why not take advantage of both?
Combining Rate Caps and Outcome-based Strategy
Based on its assessment of how long [liftoff] is likely [to] take, the Committee would then commit to capping rates out the yield curve for a period consistent with the expected horizon of the outcome-based forward guidance. If the outlook shifts materially, the Committee could reassess how long it will take to get inflation back to 2 percent and adjust policy accordingly. One benefit of this approach is that the forward guidance and the yield curve ceilings would reinforce each other.
This is what the minutes pointed to: using forward guidance and rate caps to reinforce each other.
How far the rate caps should go out on the maturity spectrum would in this case be tied to the macro forecasts and specifically to the rate projections that go along with other macro projections. This would be confusing unless the rate projections (the dot plot) were consistent with that horizon for the rate caps.
Summary of Brainard’s Preliminary Thoughts
Brainard set out a comprehensive, if preliminary, set of potential revisions to the policy framework that are intended to be self-reinforcing.
▪ Outcome-based forward guidance with an inflation threshold at the policy objective. ▪ Rate caps on short- to medium-term Treasury securities over the horizon the Committee expects before liftoff.
▪ Asset purchases of 10-year Treasuries.
I have expected the outcome of the review with respect to strategy and tools to be simple and easy to communicate, in part because it was incremental and evolutionary, building on the tools used in the post-financial crisis period. That is implementing those policies more quickly and in a more aggressive way. Forward guidance with an inflation threshold at the policy objective, rather than some unemployment rate, would fit this mold. Rate caps, on the other hand, would be something new, though consistent with both forward guidance and the motivation of asset purchases, and could be explained as such.
It would likely be impossible to capture all of this in the Committee’s “Statement on Longer-Run Goals and Monetary Policy Strategy“. But that itself is OK. This would require a separate detailed statement on monetary policy strategy and tools.
Brainard’s “preliminary thoughts” are very comprehensive and well thought out and seem to be serious proposals rather than preliminary thoughts. They should be taken seriously because they are consistent with
the discussion of possible new directions in the October minutes and because Brainard is such a forceful voice within the Committee.
While I would not say there was coordination at play, it was nevertheless beneficial to have Brainard set out this set of comprehensive revisions to the framework, as opposed to Clarida or Powell, given that whatever they set out as preliminary thoughts would give the impression (perhaps correctly) that the proposals were a done deal. Her speech might also serve as a trial balloon for some proposals under consideration in the Review, allowing the Committee to hear responses to the proposals from outside the FOMC.
This may also suggest that the Committee is further ahead in its deliberations about the policy framework than they have let on. In any case, we will be “counting heads” for each of her proposals. And, of course, as suggested above, some heads count more than others. But, at least, we now have some sense of where Brainard’s head is! Other heads will enter the discussion over time. In addition, we should begin to see a discussion in the minutes that focuses more on various views about the direction of the Review, including at the December meeting.