We are heading toward the Fed’s research conference in Chicago in early June, and here I summarize, usually with quotes from recent speeches, participants’ views on strategy innovations, new tools, and communication initiatives, and offer comments on each of their discussions.
Powell: Defining the Issues
Chair Powell set out the agenda for the Review in three questions:
1. 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? 2. Are the existing monetary policy tools adequate to achieve and maintain maximum employment and price stability, or should the toolkit be expanded?
3. How can the FOMC’s communication of its policy framework and implementation be improved?
But he quickly tempered expectations about the extent of revisions that should be anticipated (all emphasis is mine):
“We believe that our existing framework for conducting monetary policy has generally served the public well, and the review may or may not produce major changes…The process is more likely to produce evolution rather than revolution…there is a high bar for adopting fundamental change.”
“When a recession comes, the Fed is likely to have less capacity to cut interest rates to stimulate the economy than in the past, suggesting that trips to the ELB [effective lower bound] may be more frequent. The post-crisis period has seen many economies around the world stuck for an extended period at the ELB, with slow growth and inflation well below target. Persistently weak inflation could lead inflation expectations to drift downward…Therefore, central banks need to find more effective ways to battle the low inflation syndrome that seems to accompany proximity to the ELB.”
“Makeup strategies are probably the most prominent idea and deserve serious attention. However, they are largely untried, and we have reason to question how they would perform in practice…In this review, we seek to start a discussion about makeup strategies and other policies that might broadly benefit the American people.”
“One of the ideas that have come up is using a range,” instead of a 2% point for the inflation objective. “I wouldn’t want to prejudge. But that is one idea [that will be considered].”
We immediately see that makeup strategies are at the top of the list of alternative strategies. Indeed, it appears from the first question that these are the only contenders he expects to be under consideration. But there are questions about how they would work in practice. There is skepticism among other participants that
I expect will temper enthusiasm for moving in the direction of explicit, full-offset makeup strategies like price level targeting (PLT), nominal-income targeting (NIT), and, perhaps, also average-inflation targeting (AIT). I would like to hear, sooner rather than later, what alternative strategies fall into the “revolutionary” camp and whether all of the above do. That will allow the Committee as well as the rest of us to focus on the merits of more evolutionary strategies. I expect, nevertheless, that the attraction of makeup policies will ultimately lead the Committee toward less demanding, more-credible strategies that still have a clear makeup “spirit.”
I was surprised to see Chair Powell show some interest in a range, as opposed to a point target, for inflation. I will return to that when I discuss Rosengren’s views on this topic.
Clarida: In the Spotlight
Clarida repeated the three questions that define the agenda for the Review, while also highlighting makeup strategies, perhaps signaling that this is the only category of alternative strategies that will receive serious consideration.
“Persistent inflation shortfalls carry the risk that longer-term inflation expectations become poorly anchored or become anchored below the stated inflation goal. In part because of that concern, some economists have advocated ‘makeup’ strategies under which policymakers seek to undo, in part or whole, past inflation deviations from target.”
“[Makeup] could be implemented either permanently or as a temporary response to extraordinary circumstances. For example, the central bank could commit, at the time when the policy rate reaches the ELB, to maintain the policy rate at this level until inflation over the ELB period has, on average, run at the target rate…[Such makeup] strategies lead to better performance on both legs of the dual mandate, [but] any makeup strategy, to be successful, would have to be understood by the public to represent a credible commitment. That important real-world consideration is often neglected in the academic literature, in which central bank ‘commitment devices’ are simply assumed to exist and be instantly credible on the decree.”
Concerning new tools, the only one Clarida has mentioned is yield curve control, as implemented by the BOJ. This would be implemented at the ELB, by establishing a “temporary ceiling for Treasury yields at longer maturities by standing ready to purchase them at a preannounced floor price.”
“As part of the review, we will assess the Committee’s current and past communications and additional forms of communication…there might be ways to improve communication about the coordination of policy tools or the interplay between monetary policy and financial stability.”
First, the only alternative strategies he discusses are “full offset” commitment-based makeup strategies. Let me emphasize the word “commitment” here. In the past, the FOMC has made conditional guidance, never a commitment. To be sure, commitment strategies will be more effective in maintaining well-anchored inflation expectations, but would the Committee ever adopt a full-commitment strategy? I doubt it.
Second, while he repeats Powell’s guidance that any changes would likely be evolutionary, not revolutionary, he did not apply that litmus test to PLT and NIT. He might have had to classify them as revolutionary if he did, which I expect will be the Committee’s ultimate verdict.
Third, he emphasizes the challenge of convincing markets that any makeup policies would be credible. This problem may be insurmountable, especially in cases where inflation is above target: To honor the makeup commitment, policymakers would have to raise rates high enough and for long enough to raise the unemployment rate so much and for so long to lower inflation to below the objective, to offset the
a period where inflation was above the target. That suggests that were the Committee to move to a commitment policy, it would be as a temporary policy at the ELB and an asymmetric commitment. Concerning inflation above the target, perhaps let bygones be bygones!
Fourth, I was surprised he mentioned yield curve control, given that, as he noted, the Committee previously considered this approach but found it “wanting” and opted instead for LSAPs, maturity transformation, and forward guidance to affect the yield curve. In the previous consideration of yield curve control—referred to at the time as simply targeting longer-term yields—the Committee was concerned that adjusting quantities to hit a rate target could result in a larger-than-acceptable increase in the size of the balance sheet, or even a loss of control of the size of the balance sheet. Rather than setting a target for a rate and carrying out whatever asset purchases needed to meet that target, the FOMC has set a target for asset purchases and accepted whatever the effect was on longer-term yields. Of course, this could be repeated to lower long-term yields further. In any case, perhaps he thinks a reconsideration of yield curve control is in order, given the apparently successful implementation by the BOJ. I doubt yield curve control will get much support.
Fifth, if the Committee moved to a makeup strategy, it would, as Clarida said, have to decide between making it permanent or enacting it temporarily in the case of extraordinary circumstances (perhaps not so extraordinary in the future!). On the one hand, makeup policies would be a nuisance if the shortfalls were small, say a couple of tenths for a couple of years. On the other hand, a makeup strategy would be more credible if it were implemented in normal times before it became more valuable at the next encounter with the ELB. And finally, if not implemented in normal times as well as in crises, a makeup strategy would lose some of its ability to deliver an average inflation rate at the Committee’s objective.
Sixth, it is natural that the Committee would consider communication about the coordination of policy tools. The initial guidance on asset purchases was not clear enough about the coordination of funds rate policy and balance sheet policy. The lack of clarity became a source of market concern, but the guidance was later clarified, at least to a degree.
Seventh, Clarida raises an important issue (that is often cast aside) without any elaboration: the intersection of monetary policy and financial stability. This issue has been cast aside by the apparently official view that macroprudential policy effectively guards against threats to financial stability, leaving monetary policy to focus solely on the dual mandate. But, given that post-financial-crisis regulation has made the banking sector more resilient, today, the Committee’s concern has been about threats to financial stability resulting from market imbalances, but without a well-thought-out strategy of using monetary policy temper such risks. Indeed, makeup strategies are likely to aggravate this problem. I wonder to what extent the intersection of monetary policy and financial stability will get serious consideration in the Review. I expect it will only be raised as a concern related to makeup policies, but with no new guidance on whether and how monetary policy has a role.
Evans: Toward a Policy-Relevant Definition of Symmetric
President Evans notes that both PLT and AIT can deliver “very good macroeconomic outcomes in the presence of the zero lower bound.” That’s in theory and in models that assume rational expectations.
He also notes that “these theoretical results rely crucially on the public believing the monetary authority can deliver periods of above-target inflation following episodes at the ELB—and that it will follow through on doing so.”
He outlines what he sees as the key features of alternative makeup proposals:
▪ A commitment to provide extraordinary policy accommodation during and after the ELB episodes.
▪ Following protracted periods of below-target inflation, commit to having above-target inflation for some, potentially for an extended period.
▪ Following periods of above-target inflation, possibly pursue policies that might generate significant increases in unemployment.
▪ Establish credibility for the symmetry of the inflation target.
▪ “I think the Fed must be willing to embrace inflation modestly above 2 percent as often as 50 percent of the time. Indeed, I would communicate mild comfort with core inflation rates of 2-1/2 percent, as long as there is no obvious upward momentum and the path back toward 2 percent can be well managed.”
Should we do this only at the zero bound, or also in normal times? Evans answers this forcefully: “Establishing this credibility today during benign times will not only achieve our current inflation goal but also help us in the future.”
Evans’ definition of symmetry regarding the inflation objective is different from how symmetry has been carried out and interpreted by the Committee. The current interpretation was set out when the Committee first inserted this word before “inflation objective” in the statement on strategy in 2016. At that time, it was said that this was just a clarification of existing policy practice, rather than a strategy innovation: Inflation will sometimes be above and sometimes below the inflation objective. In each case, the policy response would be to adjust the fund’s rate to push inflation back to the objective.
Evans goes beyond this, inserting a makeup element to the symmetry of the inflation objective. True, that wider interpretation of symmetry still leaves it short of PLT and AIT, as Evans likely intended. In Evans’ proposal, there is a makeup element, but not a commitment to fully offset deviations in one direction with deviations in the other. This is a softer, less demanding, and more evolutionary approach that nevertheless captures the spirit of AIT and leans in the direction of achieving an average inflation rate of 2%, without a commitment to do so.
To be sure, Evans might see his proposal as mirroring explicit makeup policies by proposing that policymakers set a goal of inflation being above and below 2% equal amounts of time. But that may be even more demanding than AIT, would not necessarily lead to a full offset, and isn’t even necessary to guarantee the full offset that AIT promises. Evans’ offset is in terms of time, not in terms of inflation.
Having said that, Evans’ proposal goes in the right direction, in my view, and is evolutionary rather than revolutionary. Indeed, it might not even warrant a change in the statement of strategy! If Evans’ proposal were modified to focus on inflation outcomes rather than periods of time and to remove any sense of commitment, his direction could be a winner among alternative strategies.
Williams: Average-Inflation Targeting
“The problem we need to solve these days is the risk of inflation that is persistently too low, rather than too high.”
“In theory, both average-inflation and price-level targeting can solve the problem of anchoring inflation expectations at the target rate while maintaining a low inflation target rate amid low neutral rates.” The “in theory” caveat is the credibility and time inconsistency problem, always lurking in the background with
makeup strategies: “Neither [AIT nor PLT] will likely be effective in practice unless communicated clearly and carried out consistently over time.”
I would, in particular, like to hear Williams explain how AIT differs from PLT in practice. After all, PLT is a pure average-inflation targeting strategy. True, he apparently found a way to do so in his specification of the policy rules in a recent simulation study. But, for a wider understanding of this, and me as well, John, please use your words!
Daly: Conditional Support for AIT
“We will frequently find ourselves fighting inflation from below our target. While we’ve been very good at the Fed at anchoring inflation expectations…it means they matter now more than perhaps they have in the past.”
“There are three viable alternative strategies at the ELB: Nominal-income targeting, price-level targeting, and average-inflation targeting…all designed to ‘make up’ misses…but different from our symmetric inflation targeting today. In symmetric inflation targeting, you simply bring inflation back to two if you are away from two; but if you have average inflation targeting you want to make up for this past miss.”
“One of the things that are important is they have to be able to communicate and I would argue that if you just think about it average-inflation targeting would be a little bit easier to communicate than nominal- income targeting or price- level targeting simply because we have people trained more or less to think of us having a 2% target.”
She raised important questions that remain about AIT and that will prompt skepticism: “Is the required averaging window of ‘reasonable’ length? Is AIT effective if expectations are backward-looking? Does AIT work well if some households do not participate in financial markets? Would AIT be credible? Should it be a temporary policy at the ELB?”
She assesses the performance of “ordinary” inflation targeting, PLT, and AIT in a simulation study by staff at the San Francisco Fed, using a New Keynesian economic model in which some agents have backward-looking expectations. She offers a specific policy rule in that model that captures AIT: The FOMC responds to the average of deviations from 2% over the last six quarters at a rate of 1⁄4 per quarter.
“You have to have the credibility for this to be effective and I would argue that calls for needing to adopt it before you hit the ELB, not when you hit the ELB…It implies that we’re going to have to have a willingness to disinflation if necessary…credibility keeps coming back as the important thing I do think.”
“I find AIT an attractive option…but credibility keeps coming back as the important thing…the bar for change is high.”
OK, she likes AIT, but conditionally: It has to be credible, which is subject to question. But, importantly, she says the public and markets will have to see it in practice to achieve that credibility. In effect, talk is cheap.
By using a model that I think is more realistic than one with rational expectations, and getting basically the same results—PLT and AIT work better than simple inflation targeting and produce similarly good results— she brings comfort to those of us who find rational expectations “incredible”!
Rosengren: A Range, not AIT
Rosengren asks: “Are we reaching a symmetric 2% inflation target?” He notes that it is “hard to argue that the target has been symmetric. Observations of inflation have tended to undershoot the target…The 2% goal has acted more like a ceiling.”
Still, his preferred approach is not to add a makeup element to achieve a symmetric inflation objective. Rather, he proposes to set an inflation range, “for example, 1.5 to 2.5 percent.” I note he proposes this because it’s “hard to precisely hit [a point] inflation target.”
I find Rosengren’s range proposal wanting, though perhaps he is really thinking of something like the Bank of Canada’s policy framework: The BOC and the Canadian government jointly set a point inflation objective at 2%. The BOC also sets an “inflation-control range,” 1%-3%. But it aims for 2%. In an earlier commentary, I proposed that as a framework that the FOMC should seriously consider, albeit with a narrower 1.5%-2.5% range. The spirit here is a (perhaps discrete) nonlinear policy rule, where the FOMC tolerates moderate departures from the inflation objective but leans strongly against inflation beyond some boundary.
But, in his preferred proposal, as presented, it looks like the Committee would find 1½ and 2½% as acceptable as 2%. Maybe that is not what he means. Perhaps some clarification is called for. In any case, his notion of nonlinearity and tolerance zones—and specifically, an upper boundary of tolerance—merits consideration, as long as there is still a “point” inflation objective and policy is committed to bringing inflation to 2% following any deviations, albeit in a more tempered way for modest deviations than for larger actual or projected deviations.
Brainard: “Opportunistic Reflation”
“While such approaches [including AIT] sound quite appealing…There is some skepticism that a central bank would, in fact, prove able to support above-target inflation over a sustained period without becoming concerned that inflation might accelerate and inflation expectations might rise too high.”
“One possibility we might refer to as ‘opportunistic reflation’ would be to take advantage of a modest increase in actual inflation to demonstrate to the public our commitment to our inflation goal on a symmetric basis.”
“For example, suppose that an unexpected increase in core import price inflation drove overall inflation modestly above 2 percent for a couple of years. The Federal Reserve could use that opportunity to communicate that a mild overshooting of inflation is consistent with our goals…Such an approach could help demonstrate to the public that the Committee is serious about achieving its 2 percent inflation objective on a sustained basis.”
Brainard also suggests the Committee consider a new tool, the one mentioned by Clarida, implemented by the BOJ, and indeed suggested by Bernanke as an option for “making sure ‘it’ [deflation] doesn’t happen here”: “Once the short-term interest rates we traditionally target have hit zero, we might turn to target slightly longer-term interest rates—initially one-year interest rates, for example, and if more stimulus is needed, perhaps moving out the curve to two-year rates.”
“With financial stability risks likely to be more tightly linked to the business cycle than in the past, it may make sense to take actions other than tightening monetary policy to temper the financial cycle.”
She doesn’t worry about a flat Phillips curve undermining the ability of central banks to achieve their inflation objectives: “Regardless, because inflation is ultimately a monetary phenomenon, the Federal Reserve has the capacity and the responsibility to ensure inflation expectations are firmly anchored at—and not below—our target.”
I have problems with just about all of Brainard’s “policy” proposals.
First, let me say I liked the ring of opportunistic reflation. Perhaps this expression derived from the concept of “opportunistic disinflation,” a term I coined while I was at the Fed! That was about holding the line on inflation if it were above target and waiting for the next recession to lower inflation back to its objective. There is a whiff of this in “opportunistic reflation,” though she waits for reflation to occur via accidents, not the policy itself, and not necessarily by an inevitable next recession! Also, the ‘surprise” in her example is an unexpected rise in import prices. Arguably, that might call for a “look-through” strategy—unless the FOMC has moved to a price-level targeting strategy—as it presumably is a one-time increase in the price level, at best, not a move to a higher underlying inflation rate. This will not fly!
Second, Brainard (perhaps alone among participants) discusses the second challenge of the new normal, the very flat Phillips curve—the very limited responsiveness of inflation to changes in slack. But she simply rejects that this is a challenge. She says, not to worry, because inflation is a monetary phenomenon, and, as such, always controllable by a central bank. A return to monetarism? Let’s frame this in terms of how monetary policymakers strive to control inflation. It has three elements: It starts with rate hikes, as prescribed by simple policy rules when inflation deviates from the target; then, via the “transmission mechanism,’ the change in the fund’s rate affects broader financial conditions; they, in turn, affect aggregate demand and the unemployment rate; and then the Phillips curve links the change in the unemployment rate to inflation. No money in the model. Just a policy rule, IS curve, and the Phillips curve. In short, at least in my view, the Phillips curve is the only model of short-run inflation dynamics and the fulcrum through which monetary policy affects, and can therefore control, inflation. Hence, Japan, and now perhaps the euro area. Still, neither the makeup strategies nor other alternative strategies being discussed by participants can deal with this challenge. What can?
Third, I disagree with Brainard—and perhaps most FOMC participants—about relying on macroprudential policies to contain threats to financial stability, freeing monetary policy to deal single-handedly with the dual mandate Macroprudential policies are aimed principally at SIFIs and systemic risks that arise almost uniquely from their failures or near-failures. But, thanks to financial regulations, SIFIs are more resilient today. When policymakers talk about threats to financial stability today, they are focused on threats that come from markets, not so many institutions—from asset bubbles, financial imbalances, and excessive risk-taking outside of the regulated banking system. These may not rise to the level of systemic risk, but they can lead to very bad macro outcomes and these are the risks the Committee has been monitoring. I am with Jeremy Stein on this issue: Only monetary policy fills all the cracks.
While this is a worthy topic for Review. I don’t have much of an idea of how a monetary policy framework that focuses on keeping interest rates lower for longer at the ELB—and even longer for makeup strategies— could be implemented without threatening asset bubbles and other financial imbalances. That is, of course, the challenge Larry Summers has forcefully posed.
Finally, Brainard provides a spirited case for yield curve control, at least putting it on the table for consideration. George: Does 1½% Inflation Count as in the Right Place?
“Even somewhat persistent deviations from the inflation [objective], if they are limited to, say, 50 basis points above or below, may be acceptable taken in the context of broader economic conditions.”
“I am not convinced that a slight undershoot of inflation below the objective requires an offsetting overshoot of the objective.” In this respect, she agrees with Quarles. See below.
She focuses on the intersection of monetary policy and financial stability but takes a position sharply in contrast to that of Brainard. The context for George’s discussion of this was speculation about a cut in rates: She says she opposes a rate cut to boost inflation because “lower interest rates might fuel asset bubbles, create financial imbalances, and ultimately a recession.” This seems an indictment of makeup policies that would promise lower rates for even longer than at the last trip to the ELB.
Let me start with her comment that, in effect, a 1½% inflation rate is acceptable, given that the real side of the economy today is in a good place. I think the public would heartily agree with George. I have some sympathy. But I am no longer a central banker. George is. A central banker has the mandate to promote 2% inflation. And if inflation expectations are to be anchored, they should be at 2%.
What troubles me is that Williams has recently said something similar: The fact that the economy can operate at historically low unemployment rate levels without sparking inflation is “good.”
And this sentiment seems implicit in Rosengren’s range proposal. And Mester also muses as to whether the FOMC should have a range as opposed to a point inflation objective. Powell has said a range proposal was worthy of consideration. And perhaps Quarles fits into that camp as well.
On the other hand, I think many participants will likely echo her skepticism that the Committee should try to offset slight deviations from 2%.
Quarles: 1.8% is (maybe) 2.0%
“From my point of view, 1.8% is 2% [!]”—the exclamation point is mine. “I would not undergo heroic efforts, including re-thinking our monetary policy framework, or significant monetary policy stimulus, to edge 1.8% up to 2%.”
The context is not being able to measure inflation accurately enough to distinguish something close to 2% from 2% itself. But, in a broader context, I think Quarles agrees with George, perhaps for different reasons, about not responding to slight deviations from the inflation objective. But would he go so far as to say that, as a result, he views inflation anywhere between 1¾% to 2¼% as being as satisfactory as 2%, or at least “good enough for government work?” Also, some others have raised the problem that, if a makeup strategy is not implemented in normal times, it will be less familiar and less credible when it is needed more, at the ELB.
Kashkari: Try Acting as if the Inflation Objective Was Symmetric
“In my view, we have not implemented our current framework as it was designed to be implemented. For our current framework to be effective and credible, we must walk the walk and actually allow inflation to climb modestly above 2 percent to demonstrate that we are serious about symmetry.”
“Raising rates while inflation was low is an example of a shortcoming of how we implemented our framework rather than a shortcoming of the framework itself.”
“In our review, it will be easy to say that we will be more aggressive after the next downturn. Makeup strategies such as price-level targets offer this attractive feature. But we must honestly ask ourselves: If we felt compelled to raise rates when inflation was below target in this recovery, would we really keep rates low when inflation is above target next time? Count me as skeptical.”
As I noted above, the FOMC has not been, and never had thought it was, carrying out what I call a policy-relevant symmetric inflation objective. After all, under the appropriate policy, it projects inflation will be 2% in 2020 and 2021. Indeed, it never aims at inflation above 2%, just acknowledges that sometimes it will be above and sometimes it will be below. And in either case, the mantra is “don’t over-react.”
Bullard: Still Advocating Nominal-Income Targeting
Bullard is invested in NIT. Fine, but focusing exclusively on that in the context of the policy review is, in my view, perhaps making him “missing in action.”
Mester: A Communications Agenda
“I believe there are ways to enhance our communications about our policy approach that would make any framework more effective.”
She sets out three ideas:
1. Clarify how monetary policy affects the economy and which aspects of the economy can be influenced by monetary policy and which aspects cannot.
2. Clarify how uncertainty is accounted for in monetary policymaking and incorporate this uncertainty into monetary policy strategy to avoid giving a false sense of precision. “The FOMC took an important step in communicating uncertainty when it began showing 70 percent uncertainty bands around the median projections of FOMC participants, but these are not emphasized. I think they deserve more attention and should be released at the time of the post-FOMC press conference.”
3. Clarify our monetary policy strategy by taking a more systematic approach to our policy decisions and in how we communicate those decisions.
Her focus on teaching the public that “monetary policy can affect only inflation and not the underlying structural aspects of the economy such as the long-run natural rate of unemployment or maximum employment” is a worthy objective. But who is the audience here? The markets or the masses? Or perhaps the Congress? I suspect the answer is the markets. In that case, educating market participants might improve the effectiveness of the monetary policy. However, given that the FOMC has apparently been unsuccessful in explaining the uncertainty embedded in the dots after seven years, she should have modest expectations!
Her emphasis on educating about the uncertainty associated with almost everything related to monetary policy—the stars, inflation dynamics, the macro projections, and, perhaps especially, the dots—is important. Frankly, I doubt that bands around the median estimates do anything to improve the markets’ ability to understand or anticipate policy. But one hears again and again: “The FOMC never does what it says it will.” My answer is to say every time the projections are reported: “Forecasts are always wrong. So, of course, the FOMC doesn’t carry out the fund’s rate path it shows in the dots. When the outlook changes, so will appropriate monetary policy.” Better than bands!
▪ Widespread interest in makeup strategy (Powell, Clarida, Daly, Williams, Bullard) ▪ Concern about the credibility of makeup strategies, especially starting from inflation above target. ▪ I read AIT as the preferred makeup policy.
▪ An alternative is moving to a policy-relevant definition of “symmetric” (Evans, Kashkari)
▪ Some discussion of the intersection between financial stability and monetary policy (Clarida, George, Brainard)
▪ Surprising interest in a range—as opposed to pointing—inflation target (Rosengren, George, Powell) ▪ Mention of upper bound of tolerance above 2% (Evans)
▪ Mention of yield curve control as new tool (Clarida, Brainard)