Is it too soon to revisit the Fed’s 2020 monetary policy framework? No!

 

On August 27, 2020, the FOMC released a revised Statement on Longer-Run Goals and Monetary Policy Strategy. This document laid out the goals for monetary policy, articulated the policy framework, and was designed to serve as the foundation for the Committee's policy actions. The statement indicated that the FOMC intends to conduct a regular review of its monetary policy strategy, tools, and communication practices roughly every five years.

That means that the next review may take place in 2025, and, if the past review is a guide, the Fed will launch the review in early 2024 as it prepares the groundwork for (possibly) revising its policy framework. It is time to start that review now.

Outside the Fed, the review has already started. The Brookings Institution, on May 23, 2023, hosted a conference titled “The Fed: Lessons learned from the past three years.” Gauti Eggertsson and Don Kohn discussed how the FOMC’s 2020 policy framework may have contributed to its delay in responding to the surge in inflation experienced in 2021, while a panel consisting of Ben Bernanke, Olivier Blanchard, Rich Clarida, Kristen Forbes, and Ellen Meade discussed potential reforms of the FOMC’s policy framework.

With hindsight, the 2020 review resulted in a policy framework that was designed, quite clearly, to fight the last monetary policy war, the battle against an inflation rate that was systematically too low in an environment of low interest rates. It was ill-suited for the current environment of high inflation. The next policy framework needs to be robust, not tailored to one set of circumstances that could quickly change.

At its core, any monetary policy framework needs to ensure inflation remains low and stable, promote financial stability, and make certain the central bank has the flexibility to respond in the face of shocks to the macro economy. It should also facilitate the central bank’s ability to clearly communicate policy to the public.

The shift in 2020 from inflation targeting to a form of average inflation targeting (AIT) meant the Fed’s inflation goal became ill-defined and, therefore, less transparent. At the Brookings event, Kristen Forbes and Rich Clarida both noted that a target range for inflation should be given serious consideration. A range would be easy for the public to understand, while avoiding the specious appearance that the Fed can preciously control inflation.

A new statement on goals and strategy must also address the “maximum employment” part of the Fed’s Congressional mandate. This part of the dual mandate has always been harder to translate into a specific measurable objective. If the FOMC wishes to maintain its asymmetric “shortfalls of employment” language, it needs to explain more clearly the basis on which it will judge whether the economy is short of its maximum employment or not. Unemployment rates that are at historically low levels as seen recently do not require a monetary policy response when inflation forecasts remain consistent with inflation goals. However, the Fed’s poor ability to forecast inflation makes such a strategy problematic.

Besides reviewing its policy strategy, the FOMC should examine its tactics. In 2021 it argued the shocks to inflation were temporary, justifying its failure to react. However, as I discussed in "Implications of a Changing Economic Structure for the Strategy of Monetary Policy", a paper presented at the Federal Reserve Bank of Kansas City’s 2003 Jackson Hole Symposium, better outcomes can be achieved by acting as if inflation shocks will not be temporary. When faced with uncertainty about the persistence of exogenous shocks, it is better to over-estimate the shock’s persistence, not underestimate if as the FOMC did, as it was consistently surprised when shocks failed to fade away. In that same paper, I showed that a central bank seeking a policy that is robust to uncertainty about shock persistence should act as if the shock will be more persistent than it really believes. That is, even if the policymaker’s forecast is that an inflation shock will quickly dissipate, policy should be designed as if the shock will persist.

Determining exactly what policy framework should replace the 2020 one requires care review. It is time to start undertaking that review.

Robert Lucas and the rational expectations revolution

 

Few economists over the past 50 years had as great an impact on macroeconomics as Bob Lucas, who died Monday May 15, 2023 at the age of 85. When Lucas received the 1995 Nobel Prize in Economics, the Prize committee cited him “for having developed and applied the hypothesis of rational expectations, and thereby having transformed macroeconomic analysis and deepened our understanding of economic policy.”

Lucas’s 1972 paper, “Expectations and the neutrality of money,” (Journal of Economic Theory 4(2), 103-124) set out a coherent theory reconciling the long-run neutrality of money with the short-run non-neutrality of money. He did so by carefully modeling an informational friction that generated expectational errors in the short-run, errors that, because individual firms and households formed expectations rationally, could not persist. In his model, only monetary policy surprises mattered for the real economy. This result had profound implications for monetary policy. Lucas and Sargent summarized these implications in 1978, noting that policy had to be systematic, stating that “… [equilibrium methods] will focus attention on the need to think of policy as the choice of stable rules of the game, well understood by economic agents. Only in such a setting will economic theory help predict the actions agents will choose to take.” Yet policy must also be unpredictable: “the government countercyclical policy must itself be unforeseeable by private agents...while at the same time be systematically related to the state of the economy. Effectiveness, then, rests on the inability of private agents to recognize systematic patterns in monetary and fiscal policy (Lucas and Sargent 1978).

When expectations are formed rationally, having policy be systematic while also being unpredictable is a contradiction. Whatever systematic rule the central bank chose to follow would come to be understood by the public and would then make no difference for the real economy; it would matter for inflation, but not for output or unemployment. This conclusion became known as the policy irrelevance hypothesis.

Lucas offered empirical evidence for his theory in “Some International Evidence on Output-Inflation Tradeoffs.” (American Economic Review, 1973, 63 (3): 326–34). There he showed that evidence on the slope of the output-inflation tradeoff from a cross-section of countries followed “directly from the view that inflation stimulates real output if, and only if, it succeeds in "fooling" suppliers of labor and goods into thinking relative prices are moving in their favor.”

The development of the new Keynesian approach during the 1990s shifted the focus of the non-neutrality of monetary policy from informational frictions to price and wage rigidities. Today’s models are firmly based on rational expectations, relying on nominal rigidities in the form of sticky prices and wages as the rationale for the potentially significant but ultimately temporary effects of monetary policy on the real economy.

Importantly, the emphasis today is that policy must be be systematic and predictable if it is to be effective. As described by Woodford in Interest and Prices: Foundations of a Theory of Monetary Policy (2003, Princeton, NJ: Princeton University Press), “...the central bank’s stabilization goals can be most effectively achieved only to the extent that the central bank not only acts appropriately, but is also understood by the private sector to predictably act in a certain way. The ability to successfully steer private-sector expectations is favored by a decision procedure that is based on a rule, since in this case the systematic character of the central bank’s actions can be most easily made apparent to the public.” (p. 465, emphasis in original).

While Lucas’s model of monetary non-neutrality has largely been replaced, his impact on current policy discussions is still strong. Discussions of monetary policy, whether in theoretical work or in policy practice, continue to stress the importance of policy credibility and of behaving in a systematic fashion. When central bankers emphasize the important role of inflation expectations, the need to anchor expectations, and that a credible commitment to lower inflation will lessen the unemployment costs of anti-inflation policies, they are channeling the fundamental insights of Bob Lucas.