by t i m s a b l i k The Fed’s New Framework With a revised strategy, the Fed responds to challenges facing central banks today

ost people know that the Fed makes periodic changes to mone- M tary policy by changing interest rates. What is perhaps less well known is that since 2012 the Fed’s approach to monetary policy has been guided by a public strategy document that defines the Fed’s longer-run goals. The Fed has made minor updates to this framework over the years, but in August 2020, it unveiled a major revision of its policy strategy. The original 2012 statement on longer-run goals outlined how the Federal Open Market Committee (FOMC), the Fed’s policymaking body, would seek to achieve its dual mandate from Congress of maintaining maxi- mum employment and stable prices. The FOMC announced as its goal an inflation rate of 2 percent, measured by the personal consumption expen- Fed Chair delivers opening remarks at a Fed Listens event in Chicago on June 4, 2019. ditures (PCE) price index. It declined to set a specific target for maximum the Fed’s policy framework stretches would eliminate any potential confu- employment, noting that the maxi- back further than that, reflect- sion in the markets, ensuring smoother mum level of employment the economy ing changes in the challenges facing implementation of policy changes. can sustain changes over time and is central banks over the decades. Additionally, research suggested that largely driven by nonmonetary factors. announcing a long-term goal for infla- The Fed’s new framework sets a goal CHOOSING A TARGET tion would help anchor the public’s for inflation that averages 2 percent expectations for inflation, making it over time, meaning that the FOMC When Congress established the Fed’s easier to maintain stable prices over will now allow periods of higher infla- dual mandate in 1977, the FOMC was the long run. tion to make up for periods of infla- much less vocal about how it conducted By the 1990s, central banks in tion below target. On employment, monetary policy to achieve those goals. several developed countries such as the Fed’s framework now emphasizes “The FOMC didn’t announce its deci- New Zealand, Canada, and the United that full employment is a “broad-based sions when they were made; they let the Kingdom adopted inflation targets.

and inclusive goal.” Additionally, the markets try to figure them out based on The Fed waited until 2012 to formally . FOMC pledges to respond specifically the Fed’s actions,” says Andrew Levin, announce an inflation goal, but by to shortfalls from maximum employ- a professor of economics at Dartmouth then U.S. monetary policymakers were governors

of ment rather than “deviations” as in the University who served as an econo- convinced of the benefits of commu- 2012 statement, which implied that too mist at the Fed Board of Governors for nicating more openly with the public. board

much employment could be as prob- two decades. “That was standard prac- These communication strategies grew reserve lematic as too little. tice among most central banks until the out of the experiences of high inflation These revisions, which the FOMC 1980s and 1990s.” in the 1970s. But what central banks federal reaffirmed this January, were the By that time, economists and policy- did not anticipate was that starting in the

of

culmination of a year-and-a-half long makers had come to view central bank the late 2000s, they would actually face public review of monetary policy secrecy as counterproductive. Publicly the opposite problem: inflation that

conducted by the Fed. But the story of announcing monetary policy decisions was too low rather than too high. courtesy

Share this article: http://bit.ly/fed-framework 8 econ focus • first quarter • 2021 Hints of this challenge first emerged in Japan. After booming in the 1980s, Aiming at a Target the country suffered a serious recession Inflation since the introduction of the Fed’s 2 percent goal in the early 1990s. Afterward, economic 4.0 growth slowed and the Bank of Japan cut interest rates to effectively zero, 3.5 where they have largely stayed since. 3.0 “Economists first thought this was just an issue for Japan,” says Levin. 2.5 “But then in the early 2000s, the 2.0 United States had a recession where interest rates got very low. And econ- 1.5 omists started thinking very seriously 1.0 about how it’s not easy for central PERCENT CHANGE FROM YEAR AGO CHANGE FROM PERCENT banks to reduce nominal interest rates 0.5 below zero.” 0.0 The Great Recession of 2007-2009 2012 2013 2014 2015 2016 2017 2018 2019 2020 2021 saw nominal rates fall to zero in several developed economies. In the United NOTE: Based on Personal Consumption Expenditures chain-type price index. States, the Fed lowered its interest rate SOURCE: U.S. Bureau of Economic Analysis target to effectively zero in late 2008 and didn’t raise rates until the end of 2015. The Fed had only raised inter- Woodford of Columbia University 2012, the median estimate of the neutral est rates back up to 2.5 percent at the observed that “the definition of a policy fed funds rate among FOMC members end of 2018 before it started cutting prescription in terms of an inflation was 4.25 percent — 2 percent inflation them again. The COVID-19 pandemic target presumes that there is in fact plus a natural rate of 2.25 percent. Since prompted policymakers to drop rates some level of the nominal interest rate then, it has fallen to 2.5 percent. back to zero. that can allow the target to be hit (or “With interest rates generally Many economists have attributed at least projected to be hit, on average). running closer to their effective lower the increased prevalence of near- But, some argue, if the zero interest bound even in good times, the Fed zero policy rates to a global decline in rate bound is reached under circum- has less scope to support the econ- the natural rate of interest — the rate stances of deflation, it will not be possi- omy during an economic downturn at which monetary policy is neither ble to hit any higher inflation target, by simply cutting the expansionary nor contractionary. (See because further interest rate decreases rate,” Fed Chair Jerome Powell said “The Fault in R-Star,” Econ Focus, are not possible.” in a speech announcing the Fed’s new Fourth Quarter 2018.) A lower natural If a central bank consistently fails to policy framework on Aug. 27, 2020. rate means the peak interest rate will meet its inflation target while interest “The result can be worse economic be lower during economic expansions. rates remain at zero, the public might outcomes in terms of both employment When interest rates are near zero, start to question the credibility of that and price stability, with the costs of policymakers can’t lower rates much target. Indeed, observers both inside such outcomes likely falling hardest on further because individuals would just and outside of the Fed have voiced this those least able to bear them.” choose to hold cash instead of negative concern since the FOMC announced A lower neutral rate means that the interest-bearing bonds. (See “Subzero its long-run inflation goal of 2 percent. Fed is more likely to face the constraint Interest,” Econ Focus, First Quarter Except for a few brief periods, inflation of the zero lower bound during a 2016.) This can constrain conventional has persistently run slightly below the downturn. In the years leading up to monetary accommodation, resulting Fed’s target since 2012. (See chart.) the 2020 framework revision, Fed offi- in monetary policy that is tighter than cials began to explore different solu- central bankers would prefer and slow- A DIFFERENT APPROACH tions to this problem. ing economic recovery. “Broadly speaking, one can point This also poses a problem for the The apparent decline in the natural rate to two approaches: raising the infla- inflation-targeting strategies that many of interest was one of the motivations tion target without changing the policy central banks adopted. In a frequently for the Fed to undertake a review of its rule or changing the policy rule with- cited 2003 paper, Gauti Eggertsson monetary policy framework. When the out changing the target,” says Jordi of Brown University and Michael Fed first unveiled its inflation goal in Galí of the Center for Research in

econ focus • first quarter • 2021 9 International Economics, Universitat described it in 1958 — the result of “An outright decoupling of infla-

FEDERAL RESERVE FEDERAL Pompeu Fabra, and the Barcelona what he called a “quick and dirty” tion from indicators of economic slack Graduate School of Economics. analysis over a weekend — the Phillips would call into question the infla- Galí acknowledges that the first curve has served as one guidepost for tion targeting framework widely approach may seem counterintuitive monetary policymakers. It posits a link adopted by central banks over the past when the Fed has consistently fallen between employment and inflation. decades, since that framework hinges short of its 2 percent inflation target. When employment is running above critically on the existence of a posi- How could it be expected to achieve the economy’s long-run potential, infla- tive relation between inflation and the an even higher target? In his research, tion should rise, as a tight labor market level of economic activity,” Gambetti Galí argues the Fed could opportunis- puts upward pressure on wages and and Galí wrote. tically announce a higher target once prices. Conversely, when there is a lot A flatter Phillips curve would mean inflation surpasses 2 percent and then of slack in the labor market, inflation a weaker signal for when the Fed hold steady at the new target. In a pressures should be more muted. should begin raising rates to prevent world with a low natural rate of inter- There are problems with using the an overshoot of inflation. But Fed offi- est, an inflation target of 4 percent, for Phillips curve as a guide for policy cials also saw an opportunity in this example, would provide monetary poli- in practice, however. It is difficult to development. Low cymakers with more room to cut rates know the labor market’s full poten- levels weren’t placing much upward during downturns before hitting the tial, and that value changes over time. pressure on prices, but the tight labor zero lower bound. This benefit would In the late 1990s, for example, unem- market was proving beneficial for need to be weighed against the costs of ployment fell to historically low levels, workers. As part of the review of its higher inflation, however. but inflation remained low despite the monetary policy framework, the Fed Ultimately, the Fed chose to keep its Fed holding steady on rates. Evidently, held a series of “Fed Listens” events in 2 percent inflation target but adopt a the natural rate of unemployment in 2019. In these sessions, the Fed invited new strategy: flexible average inflation the economy had fallen since the prior members of the public to share their targeting. Under this approach, the Fed expansion. Conversely, the 1970s saw economic experiences. One consistent would allow inflation moderately above both unemployment and inflation rise takeaway was that minorities, includ- 2 percent following periods where at the same time — a phenomenon ing blacks and Hispanics who histor- inflation is below 2 percent. In theory, dubbed “.” ically have suffered higher unemploy- this should help boost inflation expec- After a slow recovery from the Great ment rates than whites, were finding tations for the future and give the Fed Recession, unemployment in 2019 fell more opportunities for employment more room to be accommodative. to levels not seen in 50 years. This was and advancement as the recovery Under the Fed’s old 2012 framework, beyond most estimates of the econo- gained momentum. This prompted a as the economy strengthened, the Fed my’s full potential, and many observ- renewed discussion among economists responded by raising its policy rates. ers expected inflation to start rising and policymakers about the potential This was consistent with economic as well. But wage and price inflation benefits of running an economy “hot” theory: In a world with stable inflation remained muted. Labor force partici- — that is, allowing employment to rise and inflation expectations, the natu- pation among prime-age workers (ages beyond current estimates of its long- ral rate of interest and thus the nomi- 25-54) increased as more people reen- run sustainable level. nal interest rate should move with tered the workforce, defying earlier San Francisco Fed President Mary the economy. So, as economic activity predictions of a long-term decline Daly, along with several current and heated up and unemployment reached due to the baby boomers aging into former Fed co-authors, explored this historic lows in 2017-2019, the Fed retirement. Economists and poli- idea in a 2019 paper. They found gradually raised rates. But inflation still cymakers increasingly speculated evidence that minorities, including remained below target. This puzzle that the Phillips curve relationship black and Hispanic workers, expe- prompted the other major revision to between employment and inflation had rienced greater employment losses the Fed’s policy framework regarding flattened. during downturns than whites. These its full employment mandate. In a recent paper with Luca groups also benefited more from Gambetti of Universitat Autònoma de employment gains when the labor THE PHILLIPS CURVE FALLS FLAT Barcelona, Galí presented evidence of market was already strong. Essentially, what he called “a growing disconnect less advantaged groups were typically At the center of the change are evolv- between wage inflation and unemploy- the first to suffer during recessions and ing views about the Phillips curve. In ment.” Like the falling natural rate the last to recover during economic the decades since New Zealand-born of interest, this presented a potential expansions. In light of the low inflation economist Alban William Phillips problem for inflation targeting. of recent years, some Fed policymakers

10 econ focus • first quarter • 2021 have argued that the central bank can LOOKING TO THE NEXT RECOVERY According to their latest projections, exercise more patience before tighten- most Fed officials don’t expect this to ing, allowing more time for the labor What does the Fed’s new framework happen until 2023 or later. But the Fed’s market to strengthen and benefit less mean for monetary policy during the new framework is a step into uncharted advantaged groups. post-COVID-19 recovery? For now, territory, from economic theory to the “For nearly four decades, monetary the FOMC has said the prescription real world of policy. policy was guided by a strong presump- is clear: continued accommodation. “Some policies work very well in tion that accommodation should be Unemployment is still above pre-pan- our computer simulations but may be reduced preemptively when the unem- demic levels; inflation, while it has harder to implement in practice since ployment rate nears its normal rate increased, remains below 2 percent. they require the central bank to steer in anticipation that high inflation But how will the Fed respond under inflation along a desired path with a would otherwise soon follow,” Fed the new framework when its objectives degree of precision that may not be Governor Lael Brainard said in a recent conflict? available to policymakers,” says Galí. lecture to a Harvard College “This certainly poses a risk to Principles of Economics class. their credibility, but so does This view was perhaps “We believe that conducting a review at regular doing nothing.” most famously expressed by intervals is a good institutional practice.” One thing is certain: This former Fed Chair William latest revision to the Fed’s McChesney Martin Jr. in 1955 monetary policy framework when he described the Fed as a “chap- “Inevitably, there are going to be won’t be the last. In its new state- erone who has ordered the punch bowl times when inflation is picking up, but ment on longer-run goals, the Fed also removed just when the party was really employment is still below target,” says committed to undertaking a public warming up.” While the Fed’s new Levin. Under the 2012 framework, the review of its monetary policy strategy, policy framework does not prescribe FOMC pledged to take a “balanced tools, and communication practices a particular response to achieving the approach” when considering trade-offs every five years. central bank’s goals, the FOMC has between full employment and price “We believe that conducting a review signaled a greater willingness to keep stability. Levin notes the 2020 revi- at regular intervals is a good institu- rates low as long as inflation is below sion removes that language, leaving tional practice, providing valuable feed- target. some questions about how the FOMC back and enhancing transparency and “Our new monetary policy framework will respond to conflicts between its accountability,” Chair Powell said in recognizes that removing accommoda- objectives. his speech unveiling the new frame- tion preemptively as headline unemploy- Chair Powell and other members of work. “And with the ever-changing ment reaches low levels in anticipation of the FOMC have so far stressed that as economy, future reviews will allow us inflationary pressures that may not mate- long as unemployment remains elevated, to take a step back, reflect on what we rialize may result in an unwarranted loss the Fed will not move to tighten have learned, and adapt our practices as of opportunity for many Americans,” policy unless inflation is consistently we strive to achieve our dual-mandate Brainard said in her presentation. above target for an extended period. goals.” EF

READINGS Aaronson, Stephanie R., Mary C. Daly, William L. Wascher, and Galí, Jordi, and Luca Gambetti. “Has the U.S. Wage Phillips Curve David W. Wilcox. “Okun Revisited: Who Benefits Most From a Flattened? A Semi-Structural Exploration.” Central Banking, Strong Economy?” Brookings Papers on Economic Activity, Spring Analysis, and Economic Policies Book Series, in Castex, Gonzalo, 2019, pp. 333-404. Jordi Galí, and Diego Saravia (ed.), Changing Inflation Dynamics, Eggertsson, Gauti B., and Michael Woodford. “The Zero Bound Evolving Monetary Policy, 2020, vol. 27, pp. 149-172. on Interest Rates and Optimal Monetary Policy.” Brookings Papers Levin, Andrew T. “The Design and Communication of Systematic on Economic Activity, 2003, no. 1, pp. 139-233. Monetary Policy Strategies.” Journal of Economic Dynamics & Control, 2014, vol. 49, pp. 52-69.

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