Policy tradeoff

To improve Fed policy, improve communications

Since May 2021, we have criticized the Federal Reserve’s lagging response to surging inflation. In our view, both policy and communications were inadequate to address the looming challenge. Early this year, we argued that the Fed created a policy crisis by refusing to acknowledge the rise of trend inflation, maintaining a hyper-expansionary policy well after trend inflation reached levels far above their 2% target, and failing to articulate a credible low-inflation policy.

Against this background, we commend the FOMC for its recent efforts. Not only is policy moving quickly in the right direction, but communication improved markedly. In particular, despite the increasing likelihood of a near-term recession, Chair Powell made clear that price stability is necessary for achieving the second part of the Fed’s dual mandate. We suspect that the combination of the Fed’s recent promise to make policy restrictive, along with its improved communications, is playing a key role in anchoring longer-term inflation expectations.

In this post, we focus on central bank communication and its link to policy setting. By far the most important goal of communication is to clarify the authorities’ reaction function: the systematic response of central bank policy to prospective changes in key economy-wide fundamentals—usually inflation and the unemployment rate.

To anticipate our conclusions, we argue for two changes to the FOMC’s quarterly Summary of Economic Projections to better illuminate the Committee reaction function. First, we encourage publication of more detail on individual participants’ responses to link individual projections of inflation, economic growth, and unemployment to the path of the policy rate. Second, we see a role for scenario analysis in which FOMC participants provide their anticipated policy path contingent on one or more adverse supply shocks that present unappealing policy tradeoffs (for example, between the speed of returning inflation to its target and the pace at which the unemployment rate returns to its sustainable level)….

Read More

Comments on Fed CBDC Paper

Last month, the Federal Reserve issued a long-awaited discussion paper on the possibility of introducing a central bank digital currency (CBDC) for retail use. The Fed paper calls for comments on the benefits and risk of introducing a U.S. CBDC, as well as on its optimal design. In this post, we respond to each of the 22 questions posed in the discussion paper. For the most part, these responses are based on our previous analyses of CBDC (here and here).

At the outset, we highlight our doubt that the benefits of a U.S. CBDC will exceed the risks. In our view, other, less risky, means are available to achieve all the key benefits that CBDC advocates anticipate. Moreover, we are not aware of sustainable design features that would reduce the risks of financial instability that many analysts agree will accompany the introduction of a digital U.S. dollar.

However, this overall judgment regarding a CBDC’s benefits and risks is sensitive to two considerations that appear in the Fed’s analysis either explicitly or implicitly. First, CBDC may be a less risky alternative to stablecoins, should regulation of the latter prove politically infeasible (see our earlier post). Second, if other highly trustworthy financial jurisdictions (with convertible currencies, credible property rights protections, and free cross-border flow of capital) offer their own CBDC, the case for a U.S. CBDC—as a device to sustain widespread use of the dollar—would become stronger.

Against this background, we applaud the Fed’s conservative approach. Most important, the U.S. authorities are not rushing to act. Instead, they are thinking carefully about the design elements, are actively engaged in public outreach, and have committed not to proceed without first securing broad public support….

Read More

Stagflation: A Primer

The term stagflation came into common use in the mid-1970s, when many advanced economies experienced higher inflation and slower growth than they had in the 1960s. At the time, the joint behavior of inflation and economic growth confused many economists. Throughout the 1950s and 1960s, growth and inflation generally moved in the same direction. Most important, inflation tended to fall during recessions and to rise in booms. Stagflation meant that these two key summary measures of macroeconomic performance moved in opposite directions. What caused this dramatic, painful, and persistent shift?

To understand the sources of stagflation in the 1970s—and how we subsequently avoided a repeat of that episode (at least so far)—we start with the simple premise that there are two types of disturbances hitting the economy: demand and supply. The first, changes in demand, moves inflation and growth in the same direction. The broad array of things that shift demand include fluctuations in consumer or business confidence, shifts in government tax and expenditure policy, and variation in the appeal of imports to domestic residents or of exports to foreigners. When any of these goes up or down, inflation and output rise and fall together.

Supply disturbances—which alter the cost of production—are fundamentally different. These stagflationary shocks move growth and inflation in opposite directions. For example, an adverse supply shock that raises the cost of production at least temporarily drives inflation up and growth down.

Importantly, these cost shocks cannot be the whole story behind a decade-long surge of inflation. Whether the consequences of a cost shock are one-off adjustments in the price level or an increase of the trend of inflation depends on the monetary policy response. Put differently, monetary policy determines whether we experience stagflation over any longer interval….

Read More