The Review: What to Watch For

We are heading toward the Fed’s June research conference in Chicago, a key part of its Review of Monetary  Policy Strategy, Tools, and Communications, and here I discuss the motivation and set out a checklist of what to watch for. Frankly, given the agenda (available here), I expect limited public discussion of many of the items on the checklist at the June conference. But you will find items in the checklist that FOMC  participants have already discussed and shared their views on. In my second commentary in this series, I will compile and discuss comments from FOMC participants on topics related to the review. My final commentary in this series will be my speculation—and I emphasize speculation—on innovations in strategy, tools, and communications that might result following the Committee’s internal deliberations. 

Adapting to Change 

While a case could certainly be made for conducting regular reviews of a central bank’s monetary policy framework—as the Bank of Canada does, for example—the Fed’s review is event-driven: A need to adapt the monetary policy framework to the new normal. 

There are two principal features of the new normal that challenge monetary policymakers: a much lower real equilibrium funds rate (r-star) that is expected to persist and a much flatter Phillips curve. The Review is principally, or entirely, about adapting to the former. 

The lower r-star leaves insufficient space for rate cuts in response to downside shocks, increasing the frequency at which policy is likely to be constrained by the effective lower bound (ELB). This leads to a policy asymmetry: It is harder to move inflation up to the objective from below than to move it down from above,  threatening a tendency for inflation to undershoot its objective. 

That challenge is exacerbated by a very flat Phillips curve, which undermines the ability of central banks to raise (or lower) inflation to the objective. While certain innovations might address the challenges of a low r star by improving the effectiveness of monetary policy at lowering longer-term real rates, increasing aggregate demand, and lowering the unemployment rate, they likely cannot resolve challenges associated with a flat  Phillips curve. The result is a crisis in central banking, evident for some time in Japan and now in the euro area. 

What to Watch for in Participants’ Remarks 

Perhaps I should say what I would like to hear about at the conference. In this spirit, I set out a checklist of what to watch for in participants’ discussions of the topics that are the subject of the Review. Note, however,  that—while all Board members and most Reserve Bank presidents will attend the June conference, and some will give opening remarks or serve as moderators—none are on the program as presenters, discussants, or panelists. After all, this is a Fed Listens to the event. 

A Checklist 

▪ The degree of support for alternative options that include some form of make-up strategy with respect to deviations from the inflation objective. So far, a focus on make-up policies has dominated FOMC  speeches. 

▪ However, we have already been told that any changes will be evolutionary, not revolutionary. That rules out, in my view, price level targeting (PLT) and nominal income targeting. Watch for confirmation of that.  We have not seen that yet. 

▪ That leaves average inflation targeting (AIT) as the survivor among make-up policies. Watch, however,  for a degree of skepticism about this direction. Indeed, expect questions as to whether a formal AIT  strategy is itself revolutionary rather than evolutionary. 

▪ One question that has already arisen about make-up policies is whether the Committee would be willing to offset a period of above-target inflation with a period of below-target inflation, especially considering the extent and duration of any rise in the unemployment rate that might be required. That has already led to some skepticism about AIT. Watch to see if that builds. 

▪ Watch especially for even more evolutionary strategies, which nevertheless retain the spirit of AIT. The leading (and only) contender at this point is what I call a policy-relevant interpretation of the symmetric inflation objective that is in the spirit of make-up policies without the implicit commitment to an average inflation objective. Not much focus on this yet. But I expect that, in the end, this could emerge as the winner among alternative strategies. 

▪ Watch for a clear explanation of how PLT, a pure average inflation targeting strategy, differs from AIT in practice, and how a policy-relevant symmetric inflation objective differs from AIT. 

▪ Watch for a continuation of the discussion of whether to implement a make-up-like AIT strategy only at the ELB or in normal times as well. There already appears to be some support for using it to adapt to the specific challenges posed by the new normal to make policy more effective at the ELB. 

▪ As part of the Review, the Board staff will assess the effectiveness of unconventional policies implemented after reaching the ELB—large-scale asset purchases (LSAPs), maturity transformation, and forward guidance. Watch for an assessment of lessons learned and how these will be part of the effort to improve policy at the ELB. 

▪ Watch in particular for support for aggressive threshold-based forward guidance at the ELB, with the threshold set in terms of the inflation rate rather than the unemployment rate. For example, setting a  threshold at or near the inflation objective would virtually guarantee an overshooting of the objective. This is also a potential winner because it can be designed to be in the spirit of make-up policies, though asymmetric, and geared to policy at the ELB. 

▪ Raising the inflation objective is already off the table. Watch for whether a negative funds rate target is  also off the table or at least has little support. 

▪ Watch for any discussion of new tools. I don’t expect new tools as an end product of the Review, but  there has already been discussion of “Yield Curve Control,” as implemented by the BOJ. 

▪ The composition of the balance sheet is also relevant here because the already-lengthy duration limits the opportunity for LSAPs and maturity transformation to be as effective as they could be. Watch for the support for composition more tilted toward the short end of the curve rather than a more neutral composition, one that more closely matches the composition of all securities outstanding. 

▪ Watch for a discussion of innovations in communications strategy aimed at clarifying any revisions to the framework, especially strategies aimed at improving the credibility of any make-up strategy. 

▪ While the Review is mostly focused on policy at the ELB, communications issues will cover a wider area. In particular, watch for further efforts to communicate the uncertainty associated with the macro and (especially) the rate projections.

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