Monetary policy reaction function

From Inflation Targeting to Employment Targeting?

Last year, the Federal Open Market Committee (FOMC) modified its monetary policy framework to focus on average inflation targeting. They stated that “appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time” after “periods when inflation has been running persistently below 2%.” At the same time, the Committee scaled back efforts to preempt inflation, introducing an asymmetric “shortfall” strategy which responds to employment only when it falls below its estimated maximum. FOMC participants view these strategic changes as means to secure their legally mandated dual objectives of price stability and maximum employment (see our earlier posts here and here).

Prior to this week’s FOMC meeting, the Committee’s forward guidance explicitly balanced these two goals. However, in what we view as a remarkable shift, changes in the December 15 statement are difficult to square with any type of inflation targeting strategy. Despite the recent surge of inflation, the Committee’s new forward guidance removes any mention of price stability as a condition for keeping policy rates near zero. Instead, it focuses exclusively on reaching maximum employment.

In this post, we provide two reasons why such an unbalanced approach is concerning. First, a monetary policy strategy that ranks maximum employment well above price stability is unlikely to secure price stability over the long run. Second, FOMC participants’ projections for 2022-24 are a combination of strong economic growth, further labor market tightening and a policy rate well below long-run norms. This mix seems inconsistent with the large decline in trend inflation that participants anticipate. While policymakers certainly can and do revise their projections, persistent underestimates of inflation fuel the perception that price stability is a secondary, rather than equal, goal of policy….

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Talking about Tapering

In May, we argued that the FOMC needed to communicate its contingency plans for what they would do should the recent inflation pickup prove more stubborn than its members expect. Such transparency makes it more likely that financial markets will respond to incoming data rather than to policymakers’ actions. By clearly laying out their reaction function, central bankers can avoid disruptions like market taper tantrums.

In June, the FOMC began to remove the self-imposed communication shackles designed to encourage “lower for longer” interest rate expectations and address inflation risks more openly. Indeed, as the above citation from Chairman Powell indicates, at their June meeting, policymakers began to lay the groundwork for scaling back their large-scale asset purchases (LSAPs).

In this post, we start by highlighting how recent Fed communication (which reveals appropriate humility about inflation projections) has helped avoid a market tantrum so far. Along the way, we discuss the various means that FOMC participants have used to express their changing views about the timing of interest rate increases (“liftoff”), even as they make clear that tapering their asset purchases will come first….

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Inflation: Don't Worry, Be Prepared

Everyone seems to be worried about inflation (see here and here). People also are concerned that the rising media salience of inflation could raise inflation expectations, leading to a sustained rise in inflation itself.

April price readings certainly boosted these worries: the conventional measure of core inflation—the CPI excluding food and energy—rose by nearly 3% from a year ago, the biggest gain since 1995. Fed Vice Chair Richard Clarida summed up the nearly universal reaction when he said: “I was surprised. This number was well above what I and outside forecasters expected.”

The experience of the high-inflation 1970s makes people prone to worrying about such things. Our reaction is different. After all, worry alone is not going to prevent a sustained pickup of inflation. Only credible anti-inflationary monetary policy can do that. To ensure that inflation expectations remain low, it is up to the central bank to make sure everyone understands how policy will respond if the latest elevated inflation readings prove to be more than temporary. As we have written before, the key is effective communications, not premature action….

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