MNI INTERVIEW: Fed Review Should Revive Pre-Emptive Rate Moves

The Federal Reserve should reintroduce in its next framework review slated for 2025 its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it followed for more than three decades before abandoning it in 2020, a former New York Fed staffer told MNI.

Fed officials adjusted their framework in 2020 to take a more relaxed view by allowing for periods in which inflation would run slightly above the central bank’s 2% target, to make up for past episodes in which inflation ran below the target.

"The bottom line is this asymmetry in the loss function coupled with the lags in policy runs the risk of generating some inflationary bias in policymaking," said Gauti Eggertsson, who worked in the New York Fed's research department from 2004 to 2012.

Ex-Fed Chairman Ben Bernanke earlier this year suggested the central bank should reintroduce "a little bit of preemption." Fed officials over the years have described the Statement on Longer-Run Goals and Monetary Policy Strategy as quasi-constitutional.

ASYMMETRY

The last framework review in 2020 also resulted in abandoning language that monetary policy actions tend to influence the economy and prices with a lag and policy will in part reflect the medium-term outlook.

After years of slightly below-goal inflation during the sluggish recovery that followed the Great Recession of 2007-2009, the framework was also revamped to stress monetary policy would be informed by assessments of the shortfalls of employment from its maximum level.

"When you have this sort of asymmetry that you only care about employment being below and not about it being above maximum employment, if you think that your policy is working with a lag, you will then have a natural tendency to err on the side of letting the employment market run hot, which is going to have an inflationary bias ingrained in it," Eggertsson said. Pre-emption and asymmetry "are tied together and need to be revisited."

Eggertsson's 2003 paper with Michael Woodford on optimal monetary policy at the zero bound was cited by Fed officials in the run up to the last framework review. But his views have changed considerably since 2020, in part because the pandemic has shown the Phillips Curve to be steeper.

"There are some important nonlinearities in the Phillips Curve. That has been the big revision in my thinking," he said, while also suggesting support for a slight rise in the inflation target. (See: MNI POLICY: Fed To Consider Shift To Inflation Target Band)

Ultimately, the Fed's revisions to its monetary policy strategy and forward guidance from September 2020 contributed to the largely unanticipated surge in inflation during the pandemic, Eggertsson wrote with co-author ex-Fed vice chair Don Kohn in a recent Brookings Institution paper. Fed officials have downplayed the impact of the new framework causing the pandemic inflation, with some arguing the fault lies in bad forecasts.

FURTHER TIGHTENING

"At the time we wrote the paper, we wrote that it was a testament to the credibility of the Fed that long-term inflation expectations remain stable, but now they're starting to creep up a little bit and I am concerned," he added.

At this point, both the inflation data and the tight labor market says the Fed is not there yet, he said Thursday. "Accordingly, I expect further tightening in the fall. I would not be surprised if the tightening cycle extends beyond the November meeting."

"The Federal Reserve needs to keep raising rates until we see greater balance between the number of workers firms are trying to hire to the number of unemployed workers."