The Murky Future of Monetary Policy

The Murky Future of Monetary Policy

The attached paper entitled “The Murky Future of Monetary Policy” is co-authored by Mickey D. Levy and Charles Plosser. It was presented to the September 30 meeting of the Shadow Open Market Committee and to the Hoover Institution/Stanford University Monetary Policy Symposia “The Road Ahead for Central Banks” on October 1.

Dr. Plosser is former President of the Federal Reserve Bank of Philadelphia. He is currently a Senior Fellow at the Hoover Institution at Stanford University.

The Federal Reserve’s first “Statement on Longer-Run Goals and Monetary Policy Strategy” published in January 2012 enhanced transparency and accountability by clarifying its interpretation of the statutory mandates established by Congress. It formally established its mandates as a 2% longer-run inflation target that it would address symmetrically, and maximum employment, even though the Fed stressed that it was not appropriate to establish a quantitative target for employment because maximum employment was not directly observable and was influenced by many non-monetary factors.

Until the pandemic, the unemployment rate fell to a 50-year low and inflation averaged modestly below 2%, while inflationary expectations remained fairly closely anchored to 2%. The Fed’s concerns that sustained sub-2% inflation could trigger a steep decline in inflationary expectations and confront the Fed with the zero effective lower bound, reducing its flexibility to lift expectations and stimulate the economy, led it to develop a revised strategy.

The Fed’s new strategic framework has introduced a flexible average inflation targeting (FAIT) process with a “makeup strategy” following periods of below-2% inflation, and an employment mandate that has been broadened to “maximum inclusive employment”. The Fed puts an asymmetric interpretation on both mandates: following a period of above-2% inflation, the Fed does not contemplate a makeup strategy with sub-2% inflation, and it emphasizes that it will assess “shortfalls” of maximum inclusive employment rather than “deviations”.

This paper describes five concerns about the Fed’s new strategic framework. First, it adds too much complexity. Second, it lacks clarity, and its insufficiently defined objectives would result in a step away from a more predictable and systematic approach to monetary policy toward a highly discretionary policy environment. This is particularly true of its makeup strategy for inflation, which lacks any numeric guidelines. Financial markets and the public can only guess about the Fed’s intermediate-term inflation objectives.

Third, maximum inclusive employment is a laudable and desirable feature of efficient labor markets, but it is determined by an array of factors that are beyond the scope of monetary policy, and stating it as a mandate may mislead Congress and the public about what the Fed is capable of achieving, exposing the Fed to politicization and risking its independence. Fourth, the Fed’s new strategy relies heavily on the Fed’s credibility to manage inflationary expectations, but simply presumes that it can credibly manage inflationary expectations. This is ironic since the Fed has never explained why its zero interest rates and massive quantitative easing following the financial crisis failed to generate 2% inflation, and its revised strategy seems to be questioning its own credibility.

Fifth, while the Fed was wise to abandon the Phillips Curve, which was analytically flawed and had not been a reliable predictor of inflation since the 1960s, the Fed did not provide any new framework for predicting inflation. Accordingly, the Fed’s new framework has broadened its interpretations of its inflation and employment mandates, but does not establish a credible strategy for how its monetary policy tools will achieve them.

Mickey Levy, mickey.levy@berenberg-us.com

Member FINRA & SIPC
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