The Review: Thoughts on the Endgame

Chair Powell and Vice Chair Clarida have given some guidance, though limited, about what revisions to  monetary policy strategy are likely and unlikely following the Review: 

1. Any revision must be evolutionary, not revolutionary. 

2. There is a preference for some type of “make-up” strategy. 

3. The new strategy must be simple enough that it can be communicated effectively to the public. 4. It must be credible. 

Let’s face it, the flexible average-inflation targeting (AIT) strategy that I adapted from Svensson’s paper at the Fed’s Chicago conference on the Review and wrote about earlier as a possible direction for the revision in the Fed’s policy strategy (link), while interesting and intriguing, does not satisfy three of these four conditions. So I move on. 

As I noted in previous commentaries, these conditions and constraints also rule out price-level targeting (PLT),  nominal-income targeting (NIT), and even average-inflation targeting (AIT) because they are revolutionary.  Any other commitment strategies are likewise ruled out. The FOMC would never adopt a commitment strategy. 

While we are told there is a high bar for a material change, I expect there is also a high bar for not making any meaningful revisions, and that means more than just better communication. And doing something would likely be in the spirit of a make-up strategy. The strategy might be implemented only at the zero nominal bound (ZNB) or also in normal times. In the latter case, I expect any make-up strategy would be implemented only when inflation is below the objective, not when it is above. It will not be a fully rule-based strategy but allow for some discretion, for example, with thresholds or offramps. 

I offer two different possibilities for revisions to policy strategy—the endgame of the Review—that I believe meet all four of the conditions I set out above and have the highest likelihood of being adopted: First, a more policy-relevant definition of “symmetric”; second, an aggressive threshold-based forward guidance, with the threshold in terms of the inflation rate rather than the unemployment rate. 

The “Symmetric” Inflation Objective Today 

When the adjective “symmetric” was attached indelibly to “inflation goal” in the Statement on Longer-Run  Goals and Monetary Policy Strategy, and in every mention of inflation objective by participants thereafter, it was introduced as only a “clarification” of the prevailing practice of the Committee. However, I suspect that many participants believe the earlier strategy treated 2% as more like a ceiling. 

So just what does “symmetric” mean as a modifier of inflation objective, as originally set out? • Recognition that inflation will sometimes be above and sometimes below the objective. • A strategy of responding symmetrically in each case. 

• Always aiming to achieve the 2% objective and never trying to make up for undershoots or  overshoots. 

Redefining “Symmetric” 

Some participants are pointing in the direction of redefining symmetric to incorporate a soft make-up element,  but not suggesting an explicit full make-up approach and hence not a commitment strategy like PLT or AIT.  President Evans has been the most forceful about this. 

Here is a somewhat rough idea of how such a redefined interpretation of a symmetric inflation objective might work in practice. 

▪ If there is a persistent undershoot of the 2% objective, the appropriate policy would be to overshoot the inflation objective subsequently, with the length and degree depending on the nature of that undershoot,  but without any commitment to a full makeup that would achieve an average inflation rate equal to the inflation objective. To be credible, participants’ projections should, at times, show an overshoot following a material undershoot. The strategy might be, and I expect would be, asymmetric. To be sure, an asymmetric “symmetric objective” would be hard to communicate. As a result, the Committee might simply say that asymmetric objective is a move “in the direction of average-inflation targeting” and clarify the details as needed and as later agreed upon for particular circumstances. That would, however, fail the transparency test and limit accountability. In any case, by asymmetric I mean a strategy that calls for an overshoot of the 2% objective after a material undershoot but that doesn’t call for raising the unemployment rate as much as would be required to provide an offset following a material overshoot, as  AIT would. The logic for an asymmetric treatment of departures from the inflation objective is that, while bringing inflation up to the FOMC’s objective calls for a lower unemployment rate—making everyone happy—bringing inflation down calls for a higher unemployment rate, and potentially well above the  NAIRU for some time—leaving nobody happy, except perhaps extreme hawks. Not credible. Don’t pretend. While such an explicitly asymmetric treatment of inflation misses would not necessarily achieve an average inflation rate equal to the FOMC’s objective, unlike AIT, the outcome would still be closer to  AIT than is the case with the current “symmetric” strategy. 

▪ There would likely be a range of tolerance above and below the 2% objective to help keep inflation expectations anchored. 

▪ If inflation is above 2% longer than acceptable, the Committee might practice “opportunistic disinflation.”  That calls for tightening only enough to hold the line on inflation—perhaps at no higher than 2½%, for example—and then waiting for the inevitable next downturn to return inflation to 2%. 

This policy is clearly different from AIT. 

▪ It is evolutionary

▪ While not a commitment to a full offset, there is a spirit of makeup. 

▪ It can be applied asymmetrically. 

▪ There is a range of tolerance.

An Aggressive Threshold-Based Forward Guidance with an Inflation Threshold 

The forward guidance practiced after the Great Recession was not implemented as quickly or aggressively as it could have been, and it was changed again and again. 

Forward guidance was first implemented in the form of qualitative language (e.g., extended period), then it was calendar-based (through some date), and then it was threshold- or outcome-based. In the last case, the threshold for consideration of moving away from the ZNB was some lower unemployment rate. (There was  also an inflation “offramp.”) The announced unemployment rate threshold, at 6½%, was in retrospect set too high relative to the estimated NAIRU at the time. The Committee could have set the threshold lower,  closer to, or even at the NAIRU. But I think it would be more effective to go immediately to threshold-based guidance once at the ZNB and to set the threshold in terms of inflation. Monetary policy is effective in increasing aggregate demand and lowering the unemployment rate, but less so concerning inflation. So the guidance should be in the following form, for example, The fund’s rate will remain at zero until inflation has returned to 2% on a sustainable basis. It could even be some level above 2%. There might still be a range of tolerance for the unemployment rate. In any case, this strategy likely guarantees an overshoot. And this is a dramatically stronger “lower for longer” strategy than was implemented, with a correspondingly greater effect on financial conditions. And there is no need for an offramp for inflation. 

What about LSAPS? 

I have not talked about revisions to the use of large-scale asset purchases (LSAPs), as that has not been the subject of discussions during the Review. There is one modification that would at least get some attention,  and that is moving from a fixed amount of purchases over a fixed horizon to open-ended LSAPs, as in QE3. 

Frankly, I would not be surprised to see LSAPs play a much smaller role when at the ZNB in the future. First,  they may be more reluctant to implement LSAPs when starting with a much larger balance sheet, as is the case today, and facing the prospect of eventually having to go through the process of normalizing both the balance sheet and rates. Second, some inside the Fed believe that the most important effect of LSAPs was to signal a more aggressive rate policy, a lower for longer strategy, and forward guidance achieves this more directly. Third, the term premium is dramatically lower today than at the start of LSAPs, and I wonder how effective LSAPs would be in reducing the term premium further, indeed when it is already near zero or even negative. And fourth, there are questions about the effectiveness of LSAPs after QE1, when markets were in extreme stress. That’s part of the argument of diminishing returns. So I suspect we may see forward guidance immediately, given how effective it is, followed perhaps by the FOMC turning to LSAPs to reinforce the effect on rates. 

Bottom Line 

To summarize, I am looking for a revised approach that has the following properties: ▪ Not revolutionary, as in the cases of PLT, NIT, and AIT. 

▪ Evolutionary, meaning approaches like adjusting the treatment of the symmetric inflation objective already in place today or threshold-based forward guidance, which was already used after the Great Recession. 

▪ Includes a make-up element, and perhaps an asymmetric one. 

▪ Easy to communicate, perhaps involving little change in the statement on strategy, and credible. 

Both of the strategies I outlined above have all of these properties and I expect will be among the revisions in strategy seriously considered by the Committee and perhaps implemented.

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