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Friday, September 4, 2020

The Fed's new monetary policy framework

The Fed's much-anticipated new monetary policy framework is now public. Fed Chairman Jerome Powell outlined the policy framework last week in Jackson Hole; you can view his speech here. Overall, I thought Powell's delivery was very good. While there's room for improvement, I think the new framework is a step in the right direction (George Selgin provides a good critique here). There were three things in Powell's speech that stuck out for me. I discuss these below. 

Shortfalls vs. Deviations

At the 22:30 mark, Powell reports what may very well be the most substantive change to the monetary policy statement. Here, he states that the FOMC will now interpret important macroeconomic time-series like GDP and unemployment as exhibiting "shortfalls" instead of "deviations" from some ideal or "maximum" level (a frustratingly vague concept). 

The practical effect of this shift is to remove (or make less prominent) in the minds of FOMC members the idea that the economy is, or will soon be, "overheating" (i.e., embarked on an unsustainable path that can only end in misery for those most vulnerable to economic recession). 

The idea of "deviation from (some) trend" seems like a plausible description of the postwar U.S. up to the mid-1980s. Severe contractions were usually followed by equally robust recoveries. However, this representation seems to break down since the "great moderation" that began in the mid-1980s. Since then, economic recessions have not been followed by above-average growth. Instead, each recession seems better described as a "growth shortfall." We're not entirely sure what accounts from this cyclical asymmetry, but it seems consistent with Milton Friedman's "plucking model." I think we can expect a stream of research resurrecting this old idea (see here, for example).

 
In any case, the upshot here is that, to the extent that "overheating" is no longer considered a serious threat, the FOMC will be less likely to implement "preemptive" policy rate hikes. This constitutes a tacit acknowledgement that the period leading up to "lift off" and what followed might have been handled better. As I wrote at the time (see my discussion here), standard Phillips Curve logic did not seem to support tightening (unemployment was above the estimated natural rate, inflation was below target, and inflation expectations were declining). But the Committee somehow talked itself into the need to "normalize," to act preemptively and not get caught "behind the curve." In fairness, monetary policy is always about balancing risks (in this case, the perceived risk of overheating). In the near future, less weight will be assigned to the risk of overheating. 
 
The Maximum Level of Employment
 
At the 22:30 mark, Powell states "Of course, when employment is below its maximum level, as is so clearly the case now, we will actively seek to minimize that shortfall..."
 
I have a hard time not interpreting "maximum" here as "socially desirable." I think most people would agree that the 2008 financial crisis caused employment to decline below its maximum level. The workers rendered idle in that episode constituted a social waste, and the Fed was right to loosen monetary policy to stimulate economic activity in the face of recessionary headwinds. 
 
But the recession induced by the C-19 is very different from standard recessions. This was laid out very clearly by St. Louis Fed President Jim Bullard on March 23, 2020: Expected U.S. Macroeconomic Performance during the Pandemic Adjustment PeriodAccording to Bullard, the temporary removal of some workers from their jobs is not, in this case, a waste of resources. The decline in employment in this case should be viewed as an investment in public health. That is, the maximum level of employment declined and its recovery is driven mostly by the contagion dynamic (as well as improvements in social distancing protocols, masking, testing, treatments, etc.). The role of monetary policy here is to calm financial markets (which the Fed successfully accomplished in March) and to aid the fiscal authority with its income maintenance programs. In short, the primary monetary/fiscal policy objective here is to deliver insurance, not stimulus. 
 
Monetary stimulus is appropriate, however, to the extent that demand factors (e.g., individually rational, but a collectively irrational restraint on spending) are inhibiting the recovery dynamic. The evidence for this is usually assumed to be found in falling inflation and inflation expectations, and declining bond yields. And usually, this makes sense, because we usually assume that recessions are caused by collapses in aggregate demand (as in 2008-09). But what if the increase in the demand for money (safe assets in general) is driven by a collectively rational fear? We'd expect to see the exact same inflation and interest rate dynamic, but the role for stimulative monetary policy would be more difficult to justify (though the desirability for insurance remains). 
 
So, maybe it is not so clearly the case now that employment is below or, at least, far below its "maximum" level. Note that a significant part of the decline in aggregate employment is coming from the leisure and hospitality sector: 
Arguably, we do not want, at this stage of the pandemic, to promote the indoor dining experiences people enjoyed earlier this year. This activity will return slowly as economic fundamentals improve. The "full employment" level of employment in this sector is clearly below what it was in Jan 2020. But, to be fair, it is entirely possible, and perhaps even likely, that the level of employment even here is lower than the "full employment" level. It's very hard to tell by how much though. 
 
Average Inflation Targeting
 
At the 24:00 mark, Powell explains how AIT will help anchor inflation expectations. Missing the inflation for a prolonged period of time will cause expectations to drift away from target and line up with the historical experience. This view of expectation formation is firmly rooted in the "adaptive expectations" tradition. That is, expectations are assumed to be formed by looking backward instead of forward
 
People sometimes claim that adaptive expectations are inconsistent with "rational" expectations. But this is not necessarily the case. In fact, it makes sense to use the historical record of inflation realizations to make inferences about the long-run inflation target if people are not sure of the monetary authority's true inflation target; see, for example, here: Monetary Policy Regimes and Beliefs
 
It's still not entirely clear to me whether FOMC members view AIT as a policy to pursue passively (i.e., let inflation creep up to and beyond target on its own) or actively (i.e., take explicit actions to promote an overshoot of inflation). If it's the former, then I'm on board with the idea. But if it's the latter, I am not. In particular, with the liquidity-trap-like conditions we're presently in, the Fed does not have the tools (or political will) to boost inflation persistently. It is likely to fail, just as the Bank of Japan failed. (I explain here why it's more difficult for a central bank to raise the inflation target than to lower it.) So, as I've advocated many times in the past, why not just declare 2% as a soft-ceiling and let fiscal policy do the rest? 
 
My view rests on the belief that missing the inflation target from below by 50bp over the past eight years is not a significant macroeconomic problem (especially given how crudely inflation is measured). The FOMC did view it as a problem, but mainly, it seems, because of the embarrassment associated with missing its target. "We are a central bank. We have an inflation target. Central banks are supposed to hit their inflation targets. We need to hit our inflation target to remain credible." This is why earlier FOMC statements emphasized the Fed's "symmetric" inflation target. That did not work and so now we have AIT which, I'm afraid, might not work either. Happily (for those who want to see higher inflation), Congress seems comfortable with the idea of producing large budget deficits into the foreseeable future.  
 
So, if we get higher inflation, it will largely be a fiscal phenomenon. The purpose of AIT is to accommodate any rise in inflation for the purpose of increasing inflation expectations and avoiding the specter of deflation (people often point to Japan as a case to avoid, by Japan seems to be doing fine as far as I can tell). There is the question of how the Fed would react should inflation rise sharply and persistently above 2%. Even if the event is unlikely, it would be good to state a contingency plan. In the past, the Fed could be expected to raise its policy rate sharply. But this event, should it transpire, will almost surely take place during an employment shortfall (since this is now the acknowledged new normal). The only prediction I'll make here is that the FOMC will have a lot of explaining to do in this event. 
 

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