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.