The Fed's maximum sustainable employment mandate

The Federal Reserves has a dual mandate, assigned to it by Congress, that calls for it to promote maximum employment and price stability. One objective of such mandates is to provide performance measures that can be used to judge whether the Fed is doing a good job. To be used for such a purpose, however, it must be possible to measure what maximum employment and price stability mean.

In the case of price stability, few think it should be interpreted literally – that some accepted index of prices should remain constant over time. Instead, price stability is normally taken to mean a low and stable rate of inflation. In 2012, the policymaking committee of the Federal Reserve, the Federal Open Market Committee, or FOMC, defined 2% inflation as the rate consistent with its mandate.

The FOMC has not been as clear in operationalizing the objective of maximum employment. In fact, they have moved to make it increasingly opaque. The FOMC's Statement on Longer-Run Goals and Monetary Policy Strategy was revised in August 2021 to define the employment goal as “a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors. . . Consequently, it would not be appropriate to specify a fixed goal for employment; rather the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level, recognizing that such assessments are necessarily uncertain and subject to revision.”

In short, the FOMC has said it doesn’t know how to measure one of its key objectives. One does have to sympathize with the FOMC – labor markets are complex, employment depends on business cycle factors but also on factors that influence labor force participation decisions, structural shifts arising from changing patterns of work (home or in the office), technological innovations that shift the types of skills demanded in the workplace, and many other factors. However, by being unable to offer guidance on this key policy objective, in contrast to the 2% inflation target, the public faces a more difficult problem in predicting Fed policy. For example, while inflation is currently well above its 2% target does the FOMC see current employment as too high or too low?

The figure shows the unemployment gap in blue (unemployment minus 4% -- 4% because that is the median projection among FOMC participants of longer-run unemployment) and the inflation gap (measured by the personal consumption price index less food and energy minus 2%). Throughout 2021, inflation exceeded the Fed's target, suggesting the need for tighter monetary policy, but at the same time, unemployment was above 4%, suggesting the Fed should not tighten. But while the unemployment gap was clearly falling, it was the dramatic rise in inflation in excess of 2% that was the chief development. By December 2012, the unemployment gap had entered negative territory, while the climb in the inflation gap, after looking like it might be pausing over the summer of 2021, jumped significantly in the Fall. Only in March 2022 did the FOMC decide to raise its policy rate.    

Since Spring 2022, the unemployment rate gap has remained roughly constant with the unemployment rate around 3.6%. Inflation peaked in February at 5.4%, ending the year at 4.4%. 

These gaps shows the economy at a moment of time. Just looking at the figure suggests the Fed still needs to focus on bringing inflation down. That will lead to some increase in unemployment, but the FOMC projections already suggest unemployment is below the level viewed sustainable. Current gaps reflect the consequences of the Fed's past policies, including its delay in responding to the surge in inflation seen in the figure. Because policy affects the economy with a lag, the Fed must be forward looking; policy decisions will depend on the FOMC's forecasts of the future path of unemployment and inflation. 

Last year, inflation was central problem the Fed had to address. In December 2022, the FOMC projections indicated members expected 2023 would end with 4.6% unemployment and core inflation at 3.5%. If these projections pan out, the economy will end this year both unemployment and inflation still too high. Fed actions will reflect the FOMC's assessment of the trade-offs between these two goals. Thus, understanding the Fed's actions will require more clarity on how it will balance the competing goals of ensuring both gaps return to zero. 

Of course, this discussion was all based on the assumption that 4% unemployment is what the Fed considers to be the rate associated with their mandate of maximum sustainable employment. Understanding the Fed's decisions in balancing the two components of its dual mandate would be aided it it could be as clear about its interpretation of maximum sustainable employment as it is about its interpretation of price stability.  

 

Super active fiscal policy (December 2022)

I have been investigating the role of super-active fiscal policies, policies that increase government spending or cut taxes as debt levels rise in joint work with Roberto Billi. We find that such polices can outperform standard inflation targeting when monetary policy is occasionally constrained by the zero lower bound. Our most recent version of Seemingly irresponsible but welfare improving fiscal policy at the lower bound extends the analysis to consider deviations from rational expectations in the form of cognitive discounting. 

Using a standard New Keynesian model subject to an occasionally-binding zero lower bound on the monetary policy interest rate and a model-consistent measure of welfare, we show that such seemingly irresponsible fiscal rules can improve economic welfare. While sensible fiscal policy and active monetary policy performs best away from the ZLB, the fiscal rules we analyze significantly reduce the time spent at the ZLB and produce overall welfare gains. 

Super-active fiscal policies are most effective with a high debt target and when debt is short-term. However, when private expectations are characterized by cognitive discounting, the performance of super-active fiscal rules deteriorates. 

Roberto and I wrote a SUERF policy brief in April 2022 was summarized our results from an earlier version of this paper that did not consider deviations from rational expectation.

The Fed Pivots: Goodbye Soft Landing – Hello Disinflation (Sept. 2022)

I've decided to post some thoughts on monetary policy. So to start things off, this post is something I wrote in September 2022 after last year's KC Fed Jackson Hole Symposium. Chair Powell's speech at Jackson Hole was short but significant. It marked  a clear pivot in Fed policy towards dealing with the surge in inflation the US was facing. Four months later, in January 2023, the Fed has moved significantly, and speculation is that next week's FOMC meeting (Jan 31-Fed 1, 2023) will see a slowdown in the rate of interest rate increases. 

So, while the following reflects events from last year, it offers a starting point for this new blog.

Last week’s monetary policy symposium at Jackson Hole WY gave international central bankers an opportunity to dust off their inflation fighting credentials – gone was any talk of soft landings and inclusive economic expansions, in were pledges to bring down inflation and, in the words of US Federal Reserve Chair Jerome Powell, “to keep at it until we are confident the job is done.”

 This new language brings to mind October 6, 1979, when Federal Reserve Chairman Paul Volker called a special Saturday meeting of the FOMC, the Fed’s policy committee, to adopt new policies procedures to fight inflation. These led to skyrocketing interest rates, the Fed’s policy rate peaked at 19.1 percent in June 1981, and two back-to-back recessions. Ultimately, though, the Volker-led Fed broke the back of inflation and ushered in the low inflation and economic stability the US enjoyed between 1985 and the financial crisis of 2008.

Today, the U.S. is experiencing inflation rates not seen since the early 1980s, and surveys find that inflation is a major concern of American households. The Pew Research Center’s April survey found that 93 percent of American households described inflation as “a very big” or “moderately big problem.” This isn’t surprising. Despite Fed protestations during 2021 that the surge in inflation was temporary, year-over-year headline inflation in July was 8.5 percent, and inflation has exceeded the Fed’s 2 percent target for 17 straight months. For many people, gains from economic expansion have been eaten away by rising prices.

At Jackson Hole, Powell made clear that, like Volcker, he is now committed to reducing inflation. He also highlighted a lesson from the past – delay in reacting makes the cost of reducing inflation higher. It is unfortunate that the Fed has only now remembered this lesson. The FOMC waited until March 2022, when inflation was over 6 percent, before slowly beginning to raise interest rates. Its response has hardly been one of shock and awe; it has taken five months to boost rates to 2.5%. In 1979 the Volcker FOMC caused rates to rise roughly the same amount in just a month. Volcker’s dramatic actions came when inflation had averaged over 8 percent during the previous five years. Inflation is not as ingrained now as it was then, but simply waiting in the hope that inflation would quickly recede was always going to be a risky strategy.

 The Fed can’t do anything about its slow start in fighting inflation, but there are three things it can do now to win the battle. First, if fighting inflation is the Fed’s priority, stick to it, and keep inflation at the forefront of how policy is communicated to the public. It is important to continue to avoid discussions of engineering a soft landing or prioritizing short run economic expansion. At this late date, these topics raise questions about the Fed’s commitment to fighting inflation. Everyone wants the smallest possible hit to the economy, but even those who might benefit most if a slowdown is avoided may also be the ones most hurt by the failure to control inflation as their limited budgets are stretched further and further.

Second, conducting monetary policy in the face of great uncertainty is a challenge, but there are lessons from the past here too. When uncertain about whether shocks to inflation are temporary or persistent, I argued at Jackson Hole almost 20 years ago that it is better to overestimate the persistence of inflation shocks, just the opposite of what the Fed did. One can hope that inflation quickly subsides, but it is best to plan for “temporary” shocks to inflation to end up persisting. Just as in fighting wildfires, it is best to respond quickly and strongly even to small fires to avoid the risk unpredictable winds convert a small fire into an inferno.

Third, clarify the Fed’s policy framework. Doing so would begin by admitting that the 2020 policy review and subsequent adoption of average inflation targeting was a mistake. With an inflation target that was no longer clearly defined and an employment goal the Fed itself described as “not directly measurable,” the new policy framework made the Fed less accountable. And, as others have pointed out, the Fed adopted a framework appropriate for a low inflation environment of the previous decade just as the global economy entered a high inflation environment.

 In 1978, Volcker’s predecessor G. William Miller was asked whether the Fed was responsible for the U.S.’s then 8 percent inflation. He responded, “I take the 5^th,” appealing to the U.S. Constitution’s protection against self-incrimination. (FOMC Transcript 9/19/1978, p. 17) Last year at Jackson Hole, Powell downplayed the Fed’s responsibility for inflation. At this year’s Jackson Hole, Powell firmly took on the mantle of Volcker, emphasizing that it is the Fed’s responsibility to ensure low average inflation. It remains to be seen which former Chairman’s legacy will guide policy over the next year.

Inflation Surges and Monetary Policy (BOJ-IMES Keynote May 2022)

In May 2022, I delivered a keynote address at the Annual Conference of the Bank of Japan's Institute for Monetary and Economic Studies. the title was "Inflation Surges and Monetary Policy". It was published in the BOJ's Economic and Monetary Studies, vol. 40, Nov. 2022 and can be found at https://www.imes.boj.or.jp/research/abstracts/english/me40-4.html.

Here is the abstract: Similarities between the 1960s and 1970s raise concerns that central banks are repeating mistakes that led to the Great Inflation. Two explanations for this earlier period of inflation, that it was due to shocks and special factors or that it was the result of political pressures on monetary policy, seem particularly relevant today. Major central banks such as the Federal Reserve and the ECB have been slow to react to the surge in inflation due to COVID-19 and the war in Ukraine. I investigate the consequences of policy delay and the impact of a more aggressive reaction, conditional on policy being delayed. In assessing the persistence of inflation shocks and in dealing with uncertainty about inflation dynamics, policymakers seem to be ignoring lessons from the literature on monetary policy in the face of model uncertainty.

One interesting finding was that in a standard new Keynesian model, delay in responding to an inflation shock could lead to increased volatility of interest rates, but the impact of delay on output and inflation was relatively small. I interpret this as a reflection of the policy of forward guidance. As long as the private sector knows the Fed will eventually respond, delaying by a couple of quarters makes little difference. As usual, therefore, the credibility of the central bank is key. Too much delay, however, can lead to instrument instability.