Q&A: Further Questions about the Framework

The Fed’s new Strategy Statement and FOMC statement forward guidance has left open some key questions
about execution. I explore some issues below and invite you to contact me directly if you would like to
discuss further.

  • What is the relevant proxy target if the goal is price stability? Should we watch inflation? Or price levels?
    • Inflation targeting is of course about targeting inflation, not the price level, and price stability does not of course mean price stability, at least to the FOMC! It has always been interpreted as a low and stable inflation rate, today 2%. And there is no proxy for “price stability”. The objective is still 2%. The only difference is not on a year by year basis (which they never achieve in any case), but on average over some time (something that is at least feasible.)
    • No, I don’t think price level targeting was ever on the table in the framework review. I said this immediately at the outset. After all, Powell said evolutionary, not revolutionary. And no rules based strategy. That immediately excluded PLT. That is too demanding, requires undershooting after overshooting, doesn’t deal with supply shocks, etc. etc. Again, never any chance of rules based, full offset policy. So, yes the Fed and other central banks should target the inflation rate, but the new strategy does at least take a step in the direction of PLT via makeup policy.
  • The new framework sounds an awful lot like inflation expectations targeting. Which measure(s) of inflation expectations will the Fed prioritize? How will the Fed weigh expectations from different sources: households vs. businesses vs. financial markets?
    • Inflation expectations are a more important consideration in the new policy framework, given the concern that they will become adaptive in periods of persistent low inflation. You cannot have price stability without inflation expectations that are anchored. Policymakers look at the full range of indicators to form their judgment and use both surveys and TIPs-related measures to detect trends. I have a commentary forthcoming about a “common index of inflation expectations,” recently developed by the Board staff that distills many survey- and market-based inflation expectations indicators into a single measure.
  • Critics say the new approach to overshooting is too vague and discretionary. Is it possible to define more clearly the calibration principles, for instance, that the Committee will overshoot to the extent it judges necessary for the duration necessary to anchor trend inflation and inflation expectations at target?
    • That’s true. We were hoping to get clarification of what “moderately” and “some time” means with respect to overshooting and what it means to achieve the 2% objective (for how many months). And the FOMC does describe the new strategy as “flexible” average inflation targeting. The FOMC certainly believes it must retain some discretion. But we sure would like more clarity on how flexible and with respect to what. But the FOMC has made it clear that the new strategy is not rules-based full offset AIT. Indeed, I don’t expect the FOMC to really hold itself accountable for achieving an average inflation rate of 2%, for example, over a five-year period. The strategy is overshooting after undershooting and that should at least move in the direction of achieving an average inflation rate over “some period.” We were surprised in any case by the discussion in the minutes that participants agreed the strategy was not an “unconditional commitment.” I would like to hear more about that. For the moment, giving the Committee the benefit of the doubt, I view that implicitly as referring to escape clauses for unwelcome movements in inflation expectations and financial stability risks.
  • The Fed has never explained why its post-GFC monetary policy failed to generate 2% inflation. How will it credibly raise inflation now to achieve its makeup strategy?
    • Actually I think the FOMC has explained this. Indeed, this was the principal motivation of the framework review, the revised strategy, and the new forward guidance, to make policy more effective at the ELB in achieving the dual mandate, and specifically achieving the 2% inflation objective. The problems in achieving that in practice were all a product of the so-called “new normal”: The secular decline in the neutral rate, leaving less “policy space” with respect to the funds rate; the flatter Phillips curve that made it harder for the FOMC to raise inflation by lowering the unemployment rate; and the prospect, as a result, of repeated periods of persistent low inflation that could unmoor inflation expectations, leaving expectations adaptive, threatening a dire situation where inflation expectations would fall to the low level of actual inflation. The FOMC responded in two ways. First, via forward guidance, trying to convince markets that the funds rate will be lower for longer, and hence lowering long term rates; and by LSAPs, compressing term premiums and directly lowering long-term rates. In the framework review, they assessed that these policies had been effective, at least in lowering the unemployment rate and raising inflation, albeit not to 2% on a sustained basis. These remain the principal tools (and only ones to be implemented now). But now, based on the framework review, the effort is to be more effective with these tools, using them faster and more aggressively. This is mainly the case with forward guidance. The guidance is that the FOMC will overshoot after persistent undershoots. That will mean even lower rates for even longer, more accommodative than otherwise. Regarding asset purchases, I don’t expect much change, though I expect them to be open ended–more like QE3 than QE1 and QE2.
  • The median SEP inflation projection does not exceed 2%. Does this mean that the FOMC consensus projects that the current policy will not raise inflation above 2%? If the framework is also about managing expectations, is the FOMC thinking about any changes to its SEPs or communications?
    • No, at least it better not! After all, the credibility of the strategy will be tested by whether the FOMC projects above-2% inflation with appropriate policy. So they had better do so. And they need to deliver, that is, raise inflation “moderately” above 2% for “some time.” In the staff forecast, the horizon goes beyond 2023–I suspect always a five-year horizon. While the staff also projected no overshooting through 2023, thereafter they projected there would be overshooting. I suspect that, if the forecast horizon had been extended for FOMC participants, overshooting would be projected for after 2023, along with a decline in the unemployment rate below the NAIRU.
    • With respect to the SEP, I thought the Committee was going to discuss potential changes to the SEP at upcoming meetings, but the September minutes gave no hint of that. There’s been one change in the SEPs published since the pandemic began (June and September): no fan charts. Fine by me–I hate the fan charts and wish they were never there!
    • I have hoped that the FOMC would replace the discussion of the outlook and monetary policy at the beginning with a cohesive and clear narrative written by Powell. Does not at all require the Committee to come up with a consensus forecast. Crazy. The meeting would have to last weeks and indeed never reach a conclusion. Give the Chair the pen and let him/her spin out a narrative. No circulation to the Committee for edits. If others don’t think he did a good job, slap him on the wrist! Sorry, only a 5% chance of such a narrative.
    • Otherwise the change most discussed is to the dot plot. As you know, I love the dots. Indeed, that is the forward guidance of the Committee for policy over time, though not for the next meeting. The change that has been most talked about is to connect each participant’s macro projections with their interest rate projections, such as with a matrix. Please don’t! TMI. Too much emphasis again on diversity of views. I prefer to focus on the central tendency that will ultimately drive monetary policy decisions.
  • How important is the exchange rate channel in this new Flexible Average Inflation Targeting framework?
    • The exchange rate channel is an important part of financial conditions—rates, equity prices and exchange rate—that transmit monetary policy to aggregate demand.
    • In a paper I wrote at the Board, supported by staff simulations with FRB-US, the finding was that this channel accounted for about a third of the overall effect of monetary policy on aggregate demand via adjustment in the funds rate.
  • Is there a level of debt which creates concern about inflation more broadly? And how close to that level are we?
    • I don’t see higher debt bringing a higher risk of inflation. In the old days, we said that that was only the case if the Fed felt compelled to monetize the debt, via purchases of the new debt issued by the Treasury in the secondary market. Don’t see that as a significant risk, but others might disagree.
  • The new policy goals seem to allow more scope to tolerate greater “reach for yield” behavior— especially during the phase of inflation overshooting. Will there be a shift for more macroprudential tools to curb asset bubbles?
    • Maybe. On macroprudential policy, most other countries have a wider range of tools. In the U.S. case, Congress would likely have to approve any new ones. So more tools are not likely, but the Fed could at least ask. But I think the regulators already have imposed new regulations about bank capital and liquidity standards and also have stress tests. So I think the more important potential source of financial stability is with the unregulated shadow banking system and markets via asset bubbles, excessive leverage, and too-narrow risk spreads. The Committee says that if the tools in hand don’t sufficiently limit financial stability risks, they would turn to monetary policy. Having said that, the FOMC has never come up with a strategy of how to use monetary policy to limit financial stability risks. On the other hand, monetary policy is good at bursting bubbles!
  • If sustainability is understood in terms of the debt/GDP ratio, is there a new threshold?
    • That’s a good question and there is no agreed-upon answer. We might say we’ll know it when we see it! And we are headed toward 120% whoever wins the election. But there is what I call a “new view” about deficits and debt, associated with Summers, Furman, and Blanchard. The evidence is, to be sure, that a rise in debt-to-income ratios, ceteris paribus, raises real rates. But the neutral rate has fallen and longer-term yields are low and have declined as debt-to-income ratios have risen. So, there appears to be no urgency in this view to reduce deficits, for example, though by stabilizing and then lowering deficits, higher growth will gradually reduce the debt-to-income ratio.
  • How do the views of the Fed and other central banks on the exchange rate mechanism in monetary policy differ?
    • It is often said that this is the only channel in the case of Japan. And its importance varies depending on how open the economy is with respect to trade. In that respect, the U.S. is closer to a closed economy than an open one. Nevertheless, as I said above, the exchange rate channel is an important part of the transmission mechanism in the U.S.
  • Won’t AIT aggravate debt trends now by keeping rates very low for long relative to flexible inflation targeting? Will AIT elevate the risks from debt dynamics if you apply the makeup policy after a series of positive inflation shocks? Debt service costs will play a much bigger role. Charles Goodhart has recently argued that the conditions which helped central banks deliver low inflation are reversing. Another change in the policy environment is the unprecedented size of household, corporate and government debt. In short, is the ignorance of debt levels in the new framework merely benign neglect?
    • Wow, sorry, Charles, I don’t agree! I see the current environment as being biased toward lower inflation and have no reason to believe that will change any time soon. On the other hand, the continued rapid rise in debt will make debt service costs a larger part of the budget, potentially squeezing out other important priorities. Of course, for now, the government can borrow at extremely low rates and to the extent the government finances more in long-term debt, the problem of a rising burden of interest payments on the debt should be mitigated.
    • Benign neglect is interesting in that this has not been discussed at all in the framework review, or at least what we have heard of it. With respect to positive inflation shocks, remember that the response to undershoots and overshoots is asymmetric in the new framework. The FOMC only talks about overshooting after undershooting, never about undershooting after overshooting. Never a makeup strategy in the latter case.

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