The Fed's New Strategy: More Discretion, Less Preemption

On August 27, marking the conclusion of the Fed’s first strategic review, the Federal Open Market Committee released an amended version of their fundamental policy guide—the Statement on Longer-Run Goals and Monetary Policy Strategy. The FOMC adopted a form of flexible average inflation targeting (FAIT). Partly because the new strategy largely confirms recent Fed behavior, the response in financial markets was minimal. Indeed, market-based long-run inflation expectations were virtually unchanged this week. Perhaps the only noticeable development was a modest steepening at the very long end of the yield curve.

In this post, we identify three key factors motivating the Fed review and highlight three principal shifts in the FOMC’s strategy. In addition, we identify several critical questions that the FOMC will need to answer as it seeks to implement the new policy framework. Specifically, the shift to FAIT implies a change in the Committee’s reaction function. How does this reformulated objective influence the FOMC’s systematic response to changes in economic growth, unemployment, inflation and financial conditions? Under FAIT, the effective inflation target over the coming years also now depends on past inflation experience. What is that relationship?

Average Inflation Targeting

The Federal Open Committee’s first-ever comprehensive monetary policy review looks to be coming to an end. Since the announcement on November 15, 2018, the Fed has focused on strategies, tools, and communications practices, and engaged the public through numerous Fed Listens events, including a conference at which invited experts proposed new approaches (see our earlier post). At its July meeting, the FOMC discussed potential changes to its Statement on Longer-Run Goals and Monetary Policy Strategy—the “foundation for the Committee’s policy actions”—with the aim of finalizing those changes soon. And, Chairman Powell is scheduled to speak this week about the “Monetary Policy Framework Review” at the annual Jackson Hole Economic Policy Symposium.

Perhaps the most important issue on the review agenda is the FOMC’s inflation-targeting strategy. Since 2012, the FOMC has explicitly targeted an inflation rate of 2% (measured by the price index of personal consumption expenditures). A key objective of FOMC strategy is to anchor long-term inflation expectations, contributing not only to price stability, but also to “enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.” Yet, since the start of 2012, PCE inflation has averaged only 1.3%, prompting many policymakers to worry that persistent shortfalls drive down expected inflation (see, for example, Williams). And, with the Fed’s policy rate now back down near zero, falling inflation expectations raise the expected real interest rate, tightening financial conditions and undermining policymakers’ efforts to drive up growth and inflation.

In this note, we discuss one alternative to the current approach that has gained wide attention: namely, average inflation targeting. The idea behind average inflation targeting is that, when inflation falls short of the target, it creates the expectation of higher inflation. And, should inflation exceed its target, then it would reduce inflation expectations. Even when the policy rate hits zero, the result is a countercyclical movement in real interest rates that enhances the effectiveness of conventional policy….

Protecting the Federal Reserve

Last week, President Trump tweeted his intention to nominate Dr. Judy Shelton to the Board of Governors of the Federal Reserve System. In our view, Dr. Shelton fails to meet the criteria that we previously articulated for membership on the Board. We hope that the Senate will block her nomination.

Our opposition arises from four observations. First, Dr. Shelton’s approach to monetary policy appears to be partisan and opportunistic, posing a threat to Fed independence. Second, for many years, Dr. Shelton argued for replacing the Federal Reserve’s inflation-targeting regime with a gold standard, along with a global fixed-exchange rate regime. In our view, this too would seriously undermine the welfare of nearly all Americans. Third, should Dr. Shelton become a member of the Board, there is a chance that she could become its Chair following Chairman Powell’s term: making her Chair would seriously undermine Fed independence. Finally, Dr. Shelton has proposed eliminating the Fed’s key tool (in a world of abundant reserves) for controlling interest rates—the payment of interest on reserves….

Improving U.S. Monetary Policy Communications

Tomorrow, June 4, we will present our paper, Improving U.S. Monetary Policy Communications, as part of the Federal Reserve’s review of its monetary policy strategy, tools, and communications practices. This post summarizes our methodology, analysis and recommendations.

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Since the mid-1990s, the U.S. economy has been reaping the benefits of a credible commitment to price stability, including a communications framework that reinforces that commitment. Over the same period, both the level and uncertainty of inflation have declined (see here). It is against this backdrop that we look for further enhancements in the Federal Open Market Committee’s (FOMC) communications framework.

Trump v. Fed

Last month, interrupting decades of presidential self-restraint, President Trump openly criticized the Federal Reserve. Given the President’s penchant for dismissing valuable institutions, it is hard to be surprised. Perhaps more surprising is the high quality of his appointments to the Board of Governors. Against that background, the limited financial market reaction to the President’s comments suggests that investors are reasonably focused on the selection of qualified academics and individuals with valuable policy and business experience, rather than a few early-morning words of reproof.

Nevertheless, the President’s comments are seriously disturbing and—were they to become routine—risk undermining the significant benefits that Federal Reserve independence brings. Importantly, the criticism occurred despite sustained strength in the economy and financial markets, and despite the stimulative monetary and fiscal policies in place….

Commentary

Money, Banking, and Financial Markets