MNI: Fed To Examine If Framework Robust To Any Scenario

MNI (WASHINGTON) - The Federal Reserve’s review beginning in January is likely to aim for an easier-to-understand and more robust framework fit for all scenarios in a world in which supply shocks are more likely, former Fed officials told MNI.

The last such review, in 2020, tilted toward an expansion of its maximum employment mandate and adopting flexible average inflation targeting, but these strategies were designed to permit more policy accommodation in a low-rates environment. That policymakers were fighting the last war was swiftly exposed in the pandemic-driven supply shock, when officials set forward guidance pledging not to hike until employment reached maximum levels and inflation was at 2% and rising, little suspecting it was to soar to a 40-year high.

These missteps highlight the need to better communicate uncertainty about how the economy is likely to evolve, and to reaffirm that ordinary monetary policy with a conventional inflation target can apply in normal times, the former Fed officials said.

"I'd be very cautious about forward guidance, and in particular making current commitments to future actions, particularly when you're very uncertain about the environment in which you might make future actions," former Dallas Fed President Robert Kaplan told MNI. "That to me is the overwhelming communication lesson that I would hope the Fed has learned from the last framework review."

'SHORTFALLS'

Fed officials have already begun to incorporate scenario analysis into their public remarks, recognizing the advantage of discussing their reaction functions across a range of potential economic developments. (See MNI INTERVIEW: Fed's Average Inflation Target Loses Its Luster) 

Former Fed officials said that what is key for the framework is that its strategies apply under all economic circumstances. To that end, the Fed may need to clarify that some of the changes in 2020 are targeted to situations in which inflation is persistently low and policy is pinned at the effective lower bound. 

"When you're out of that situation, you have to do ordinary policy," former St. Louis Fed President James Bullard told MNI.

The 2020 commitment to allow inflation to exceed target temporarily and to respond to "shortfalls" from maximum employment rather than to "deviations” as in the 2012 framework, has been interpreted as a move away from preemptive policy actions. But that need not be the case in all circumstances. 

Research presented at the Jackson Hole conference this year probed whether there is a kink in the Phillips curve, a point beyond which there is an inflation cost to an overheated labor market.  

KEEPING FAIT

"Some people said by moving to 'shortfalls' from 'deviations,' it means monetary policy would no longer act preemptively. It seemed to me more a statement about the unreliability of estimates of u-star. This is something that has different meaning to different people,” Ellen Meade, a former special adviser to the Fed Board of Governors and Vice Chair Richard Clarida who was involved in drafting the last framework changes, told MNI.

Former Chicago Fed President Charles Evans said the 2020 framework change under which the central bank is less likely to respond to a robust job market warrants more explanation. 

"It’s very important to communicate what you mean by shortfalls," Evans said. "It doesn’t mean you can’t be preemptive. It means that in an economic environment where more people are enjoying the benefits of a good economy, you need better reasons for taking that away to some extent. You need to be able to explain why that is."  

The Fed's 2% inflation target is not up for debate, and the former officials agreed that the pledge for flexible average-inflation targeting (FAIT) is worth keeping in a world of still-low real interest rates. This states that "following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time"

But the FOMC should make clear when the pledge applies and could do so without changing the framework, Evans said. "FAIT is state-contingent too," he said.