Delivering the opening remarks at the Kansas City Fed’s annual Jackson Hole Symposium on 27 August 2020, Jerome Powell, Chair, Board of Governors, Federal Reserve System, discussed the first ever review of the FED’s monetary policy framework. Earlier in the day, the FED had released a revised Statement on Longer-Run Goals and Monetary Policy Strategy, which laid down its goals, framework for monetary policy, and would serve as the foundation for policy actions.
As the economy evolves, the FOMC’s policy framework – its strategy for achieving its goals – also needs to adapt. Powell recalled that forty years earlier, high and rising inflation was the biggest challenge requiring a “clear focus on restoring the credibility of the FOMC’s commitment to price stability”. The monetary policy initiatives of then Chairman, Paul Volcker, followed by Alan Greenspan, stabilised inflation and inflation expectations during the 1990s at around 2 percent, laying the foundation for a long period of stability known as the Great Moderation.
The Great Moderation itself led to its own challenges. Before this, expansions ended in overheating and rising inflation. With the Great Moderation, the ending was typically periods of financial instability, requiring coordinated efforts to bolster the strength and resilience of the financial system.
Inflation targeting, in place in most advanced countries by the early 2000s, required increased communication and transparency, reflecting the idea that policies are most effective when clearly understood by all stakeholders, especially, the public. Economic stabilisation also got factored into an inflation objective under a flexible inflation targeting framework.
Bernanke adopted many features associated with flexible inflation targeting, including great advances in transparency and communication, with quarterly press conferences, and Summary of Economic Projections. Janet Yellen, then Board Vice Chair, led the initiative to codify the monetary policy approach of the FOMC. This resulted in the Committee issuing its first Statement on Longer-Run Goals and Monetary Policy Strategy in January 2012. This articulated the long term inflation goal of 2 percent. There was no maximum target for unemployment, as the labour market is influenced by several nonmonetary factors. Nevertheless, it underlined the Committee’s commitment to the two congressionally mandated goals, and reflected past experience of dealing with high inflation and practising flexible inflation targeting.
Motivation for the Review
A review was required because the 2012 version came in the early period after the financial crisis had fully unfolded. In the period since then, monetary policy has further evolved. Further, the understanding of four key economic developments has evolved.
First, assessments of the potential, or longer-run, growth rate of the economy have declined, reflecting slowing population growth, aging of population, and decline in productivity growth.
Second, estimates of the neutral federal funds rate, the rate consistent with the economy operating at full strength and with stable inflation, have fallen substantially. This reflects a fall in the equilibrium real interest rate, influenced not by monetary policy but fundamental factors such as demographics and productivity, which also drive potential economic growth.The implication for monetary policy is that, with interest rates closer to their lower bound even in good times, the Fed has less scope to support the economy during an economic downturn. This will result in worse economic outcomes in employment and price stability, with more than proportionate effect on the margins of society.
Third, long period of growth till early 2020 meant that unemployment rate was near 50-year lows for roughly 2 years. Further, labour force participation rate flattened out and began rising even though population ageing suggested that it should keep falling. The participation rate of those in their prime working years fully retraced its post-crisis decline, defying assessments of permanent structural damage. As the long expansion continued, the gains were shared more widely with Black and Hispanic unemployment rates, and the differentials with white unemployment rate reaching record lows. The labour market delivered life-changing gains for many individuals, families, and communities at low income levels.
Fourth, against expectations, in a flattening of the Phillips curve, inflation rates remained muted even as unemployment rates falling below the natural rate of unemployment. Longer-term inflation expectations, an important driver of actual inflation, and global disinflationary pressures may also have been holding down inflation.
The persistent undershoot of inflation from the longer-term goal of 2 percent is a cause for concern, as low and stable inflation is essential for a well-functioning economy. Low inflation can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.
Expected inflation feeds directly into the general level of interest rates. Well-anchored inflation expectations are critical for giving the Fed the latitude to support employment when necessary without destabilizing inflation. If inflation expectations fall below the 2 percent objective, interest rates would decline in tandem. This would less scope to cut interest rates to boost employment during an economic downturn.
Elements of the Review
Keeping the above developments in view, the review was based on extended public engagement through a series of Fed Listens events around the country, a flagship research conference, and a series of Committee discussions supported by rigorous staff analysis. A clear takeaway from the 15 Fed Listens events was the importance of achieving and sustaining a strong job market, particularly for people from low- and moderate-income communities.
New Statement on Longer-Run Goals and Monetary Policy Strategy
The revised statement was adopted unanimously, despite the federal basis of the Committee’s constitution. It explains how the Congress mandate has been interpreted, and the broad framework that will best promote maximum-employment and price-stability goals.
The areas of continuity include the belief that a numerical goal for employment is unwise. This is because the maximum level of employment is not directly measurable and changes over time for reasons unrelated to monetary policy. The significant shifts in estimates of the natural rate of unemployment over the past decade reinforce this point. There is also no change in the view that a longer-run inflation rate of 2 percent is most consistent with the mandate to promote both maximum employment and price stability.
The Committee continues to believe that monetary policy must be forward looking, taking into account expectations of households and businesses and the lags in monetary policy’s effect on the economy. Thus, policy actions continue to depend on the economic outlook as well as the risks to the outlook, including potential risks to the financial system that could impede the attainment of its objectives.
The new statement takes into account the challenges posed by interest rates being close to the effective lower bound. By reducing the scope to support the economy by cutting interest rates, this increases downward risks to employment and inflation. Towards this, the Committee will use its full range of tools to support the economy.
The revised statement emphasises that maximum employment is a broad-based and inclusive goal. This reflects the appreciation of a strong labour market, particularly for those in low- and moderate-income communities. The revised statement says that the policy decision will be informed by “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level”. This reflects the view that a robust job market can be sustained without inflation.
Going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by unwanted increases in inflation or the emergence of other risks. When employment is below its maximum, as is the case now, the shortfall will be minimised using tools to support economic growth and job creation.
There have also been changes to the price-stability side of the mandate, where the longer-run goal continues to be an inflation rate of 2 percent. The actions to achieve the dual mandate will be most effective if longer-term inflation expectations are well anchored at 2 percent. If inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. Inflation expectations will move below our inflation goal and pull realized inflation down. To prevent this outcome and the adverse dynamics that could ensue, the objective will be to achieve inflation that averages 2 percent over time. This approach could be termed a flexible form of average inflation targeting, which will reflect a broad array of considerations and not dictated by any formula. The other important new features include a new Statement on Longer-Run Goals and Monetary Policy Strategy conveying a continued strong commitment to achieving goals.
A thorough public review of monetary policy strategy, tools, and communication practices will be done roughly every five years.
© G Sreekumar 2021
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