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A politicized debate over the monetary policies of the Federal Reserve System has generated concerns about the future of its long tradition of deciding policy with minimal influence of noneconomic considerations. The potential arrival of two new voting members of the Fed's 12-member policy committee is not likely to materially change the Fed's course. As it happens, however, the Fed is conducting a major review this year of its monetary policy strategy. That review is timely and necessary, but the results of the review appear likely to fall short of addressing the serious challenges facing monetary policy.
The review has been prompted in part by worries at the Fed about its ability to achieve its statutory mandate of price stability and maximum employment in the event of a future recession. The concern is that the Fed's primary policy tool to address such downturns, the federal funds rate, will be constrained again by the fact that it cannot be set below zero to any significant extent. The most likely outcome of the review is that the Fed will commit itself to intentionally overshooting its inflation target after episodes at the zero bound in which it has undershot the target. Research shows that the new policy may help spur a faster recovery, but it falls short of bolder ideas such as permanently raising the inflation target.
The Current Policy Strategy
In 2012, the Fed made official what many had long believed, that it viewed an inflation rate of 2 percent as the level most consistent with its statutory mandate for stable prices and maximum employment.1 Of course, the Fed does not control inflation to the nearest decimal point on a monthly or even an annual basis. There are always new and unpredictable developments in our complex economy that push inflation away from 2 percent and unemployment away from its equilibrium, or natural, rate. The Fed's current policy strategy is to set the federal funds rate (and quantitative easing if necessary) at a level that will return inflation to 2 percent and unemployment to its natural rate within a reasonable horizon. Typically, that horizon is two to three years.
However, as the figure below shows, since inflation fell to around 2 percent in the mid-1990s, economic surprises have tended to push inflation below 2 percent more often than above. This asymmetry is especially apparent for core inflation, which excludes the effects of volatile food and energy prices. Many observers have come to believe that the Fed prefers inflation to be below 2 percent rather than around 2 percent. Indeed, prior to the 2012 adoption of the 2 percent target, a few Fed officials had expressed a preference for inflation slightly below 2 percent, although most preferred 2 percent.2 In our recent paper on US inflation, we find evidence that the equilibrium inflation rate since 1995 is somewhat lower than the Fed's target.
Fed Chair Jerome Powell, like his predecessor Janet Yellen, has insisted in post-meeting press conferences that the Fed's inflation goal is symmetric around 2 percent. If their assertions describe policy intentions since the mid-1990s, then most of the random surprises for more than 20 years have been negative. This is not as crazy as it sounds. Recent studies have noted a secular decline in the equilibrium real rate of interest since at least the 1980s. Because it is not possible to observe the equilibrium rate directly, such a development would lead to a sequence of weaker outcomes for inflation and employment than the Fed expected ex ante. In addition to this trend, the financial crisis of 2008 pushed the federal funds rate to the zero bound, and the Fed tried to compensate by using quantitative easing (QE). But, given the uncertainty surrounding the potency and potential side effects of QE, it is not surprising that the Fed ended up being less stimulative than was required to keep inflation at target.
Likely Changes to the Strategy
In the press conference after the Fed's March 2019 meeting, Chair Powell expressed some concern that the public's expectations of inflation may have settled in a bit below the 2 percent target. The Fed's surprise pause in rate hikes this year probably reflects a desire to avoid yet another dip of inflation below target. At this point, the Fed surely would prefer to overshoot the target rather than undershoot. Our research suggests there is a good chance that inflation will modestly overshoot over the next year or so, as long as unemployment remains near its current rate of 3.8 percent.
The behavior of inflation almost surely will be a key focus of this year's review of the Fed's "strategies, tools, and communications practices." With the federal funds rate possibly topping out at its current level of 2.5 percent, there is relatively little scope for rate cuts when the next recession hits. Although QE can help, there are limits to what the Fed can usefully do with asset purchases.3 These limitations raise the risk that inflation will undershoot and unemployment will be excessive for several years, as was the case after 2008.
One promising approach to boosting the potency of monetary policy at the zero bound is to promise to intentionally overshoot the inflation target after any extended period below target when policy is constrained. This policy works by raising expectations of future inflation and thus reducing the real rate of interest faced by households and firms. Using model simulations with various monetary policy rules and expectational assumptions, a paper by former Federal Reserve chair Ben Bernanke and two senior Fed staff members, Michael Kiley and John Roberts, recently found that various policy rules that commit to at least partially offsetting inflation undershoots with subsequent overshoots can substantially improve economic performance. If the Fed decides to adopt such a strategy, it would be better to do so before the next recession hits. Otherwise, a new promise to raise future inflation during a recession may not be fully understood or believed.
Should inflation begin to exceed the Fed's target by a modest amount next year, as we expect, the Fed might choose to kick off its new policy strategy by welcoming this overshoot as a partial offset to recent undershoots. A modest overshoot also would serve to raise long-term inflation expectations toward the 2 percent target.
Fed vice chair Richard Clarida recently said that the Fed's strategy review will not lead to any change in its inflation target of 2 percent. However, the economic costs of the zero bound constraint call for serious consideration of more powerful strategy changes. For example, permanently increasing the inflation target to 3 percent in combination with a limited overshooting policy would reduce the probability of hitting the zero bound and increase the Fed's firepower by more than a limited overshooting policy centered on 2 percent.
As with any proposed change to monetary policy strategy, a policy of limited overshooting would be controversial, and raising the inflation target even more so. The 2016 Geneva Report, What Else Can Central Banks Do?, provides further discussion of the pros and cons of various policy options to deal with the zero bound on interest rates.
Notes
1. The Fed does not have a fixed target for the unemployment rate because employment is affected by long-run institutional and demographic factors beyond the Fed's control. The Fed does have contemporaneous estimates of the lowest rate of unemployment consistent with low and stable inflation, sometimes referred to as the natural rate of unemployment.
2. For example, in the November 2010 Summary of Economic Projections, 11 participants in the Federal Open Market Committee listed a "longer run" inflation objective of 2 percent, 3 participants listed 1.5 percent, and 4 participants listed values of 1.6 to 1.9 percent.
3. The benefits of buying long-term bonds are limited by the zero bound on longer-term yields, which has been reached in Germany and Japan. Although US yields are notably higher than zero now, they are likely to fall significantly in the event of a recession. The Fed is limited to purchasing government-guaranteed bonds and is not allowed to buy corporate bonds or equity.
