The Murky Future of Monetary Policy

Abstract

In August 2020, the Federal Reserve unveiled its new strategic framework. One major objective of the Fed was to address its concerns over the potential consequences for the conduct of monetary policy when the policy rate was constrained by its effective lower bound. This article concludes that there are significant flaws in the new strategy and that it encourages a more discretionary approach to monetary policy and increases the risks of policy errors. The new framework is an overly complex and asymmetric flexible average inflation targeting scheme that introduces a significant inflationary bias into policy and expands the scope for discretion by broadening the Fed's employment mandate to "maximum inclusive employment." In a postscript, the article describes how quickly the flaws have been revealed and urges a reset toward a more systematic and coherent strategy that is transparent and broadly understood by the public.

Introduction

The Federal Reserve first published a "Statement on Longer-run Goals and Monetary Policy Strategy" in January 2012. The purpose was to enhance transparency and accountability by clarifying its interpretation of the statutory mandates established by Congress. The two key elements of that effort were to formally establish a 2 percent longer-run inflation target as being consistent with its price stability mandate and to stress that it was not appropriate to establish a quantitative target for maximum employment, as such a target was not directly observable and was influenced by many factors unrelated to monetary policy. This document was frequently referred to by the Fed as the "consensus statement."

During the ensuing eight years, the economy continued its recovery from the 2007-09 recession. The unemployment rate fell to a 50-year low of 3.5 percent prior to the pandemic and government shutdowns of 2020. The inflation rate remained modestly below the Fed's adopted inflation target, averaging about 1.4 percent over the 2012-19 period. In response to concerns about low inflation and the challenges facing monetary policy as interest rates approached zero, referred to the effective lower bound (ELB), the Fed announced in November 2018 its intention to review the "strategies, tools, and communication practices it uses to pursue its congressionally-assigned mandate."

The main result of this "strategic" review was revealed in a revised "Statement on Longer-Run Goals and Monetary Policy Strategy" released in August 2020. A description and rationale was provided by Fed Chair Jerome Powell at the Federal Reserve Bank of Kansas City's annual Jackson Hole symposium. The revised policy document significantly changed the Fed's interpretation of its dual mandate. The interpretation of the maximum employment mandate was broadened by the Fed to maximum "inclusive" employment, adding for the first time a distributional dimension to its objectives for monetary policy. The interpretation of the price stability mandate became more complex, but also more vague. This was done by replacing the existing inflation target (IT) with an average inflation target (AIT) that was flexible over time and included built-in asymmetries. 

We prepared this critique of the Fed's new strategic plan in September 2020 as a response to the revised framework announced in August 2020. Our view, both then and now, is that the strategy and its implementation is misguided: The attempt to include distributional objectives for the employment mandate expands the Fed's scope and rationale for policy action. This leads to a more discretionary and uncertain path of policy, increases the risks of policy errors, and makes it more difficult to hold the Fed accountable. It is ironic that while the Fed expands the scope of its employment goals, it acknowledges, as it did in the original consensus statement, and correctly in our view, that such goals may lie beyond the scope of monetary policy. 

Thus, these more-expansive (and likely unachievable) ambitions could undermine the Fed's credibility and invite greater political involvement in monetary policy decisionmaking, further eroding the Fed's independence. The new flexible and asymmetric average inflation targeting framework is confusing and lacks an explanation of how the Fed will use its tools to achieve its inflation objectives. We anticipated that this would lead to confusion in financial market and consumer assessments of the future path of monetary policy, challenging the Fed's communications and its transparency along with its credibility. We indicated that these problems meant that the new strategy was unlikely to serve monetary policy or the economy well over the longer term. 

These themes are developed below. At the end of the article, we provide a postscript that puts our critique in the light of the events in 2020-21. What is so striking is how quickly our concerns about the Fed's new strategic plan have become realities. The surge in inflation beginning in late 2020, prior to the Fed achieving its view of maximum inclusive employment, came as a surprise to the Fed, and its new strategy was not designed or equipped to confront such an occurrence. The confusion and uncertainty on the part of the public and markets in assessing the Fed's implementation of its new strategy highlighted the troubles with the underlying plan and its communication. It now seems readily apparent that the Fed needs to reassess its new strategy and address its shortcomings.