Will the Fed change its policy framework?

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Please note that this article may contain technical language. For this reason, it is not recommended to readers without professional investment experience.

Monetary policymakers at the Federal Open Market Committee (FOMC) have a problem and they have not been shy about highlighting it: most of them continue to see the real neutral policy rate [1] as depressed by historical standards and likely to remain so for years to come.

Judging by their comments and the quarterly Summary of Economic Projections, most FOMC participants believe that the real neutral rate is currently at 0.25-0.50% and likely to rise over the next five years or so to just 0.75-1.00%. By contrast, a decade ago, policymakers generally assumed the real neutral rate was at around 2%. The FOMC’s target range for the federal funds rate is now at 1.25-1.50%.

The issue for the FOMC is that it will have little scope to cut policy rates far below the – depressed – neutral level in the next recession. They will likely need to rely again on quantitative easing (QE) to provide stimulus in an economic downturn.

The use of QE comes at a political cost for the central bank. If the FOMC is only inclined to employ QE when a financial crisis comes into sight, the amount of stimulus that can be delivered with traditional rate cuts remains limited, meaning the next recession could be relatively deep and protracted, raising the risk of a descent into deflation.

Will the FOMC redefine the inflation objective…

These factors all suggest the wisdom of considering adjustments to the Federal Reserve’s policy framework that could mitigate the effects of a depressed neutral rate, as a number of reserve bank presidents (as well as former Chair Ben Bernanke) have urged.

One possibility would be to redefine the current 2% inflation objective, perhaps as 2.0-2.5% or even 3.0%.  If the FOMC were to make this change now, it would be able to ease off on raising rates further – possibly taking a protracted pause or even cutting rates – to let inflation rise to the new, higher target.

Inflation expectations would rise, and when the economy next enters a recession, it would presumably do so with higher inflation. This would allow the FOMC to cut the real policy rate further into negative territory than would otherwise be the case.

There are variations on the theme of a higher inflation objective such as raising the objective only when the economy slips into recession or when there is a persistent inflation undershoot. These variations can help avoid the buildup of financial excesses and the costs of higher inflation during an expansion.

However, they come with the added drawback of reducing the efficacy of the higher objective, since the economy would presumably enter recessions with lower inflation and a reduced scope to cut the real policy rate.

…or adopt price-level targeting?

Some policymakers, most notably San Francisco Fed President John Williams, have spoken favourably about price-level targeting. In this case, the FOMC would adjust policy to make up for deviations of a price-level index from a path that is consistent with growth at the inflation objective. As a result, during periods of below-target inflation, the central bank would commit to keep policy stimulative for as long as necessary to make up for cumulative inflation shortfalls.

Recently, Ben Bernanke proposed a variation of this idea, a temporary price-level targeting framework under which the central bank would commit to switching to price level pah targeting in periods when the lower interest-rate bound is reached.

As Bernanke explains, this approach would allow the FOMC to continue with its normal operating framework during good times, but the pre-commitment to switch to temporary price-level targeting in a lower interest-rate bound scenario would help to ease financial conditions even ahead of a recession. Inflation expectations would be supported by prospects for an upcoming framework switch. As a result, the upfront commitment to move to price-level targeting could make recessions shallower and limit the risks of deflation.

Discussions in the FOMC are just beginning…

So where does all this leave the Powell Fed? It is likely that the FOMC will indeed consider changes to its framework, but this will be a slow-moving process.  To date, the committee has not formally discussed the issue. For example, the January policy meeting minutes only contained a reference to “a few” participants suggesting study of potential alternative frameworks.

As for starting such a discussion in the near future, for example at the March meeting, it is far from ideal to do so when there are a number of vacant governor positions and when the Federal Reserve Bank of New York is in the middle of a search for a new president who will also serve as vice chairman of the FOMC.

But make no mistake, an FOMC discussion of the issue is in the offing. In addition to the growing chorus of Fed officials arguing for serious debate on the topic, the latest Monetary Policy Report (MPR) to Congress included for the first time a reference to price-level targeting in its discussion of policy rules and even a link to Bernanke’s paper on temporary price-level targeting.

We risk over-interpreting, but it is possible that Powell is using the MPR to provide the public with information on the options under consideration.

An eventual change to something along the lines that Bernanke has suggested is a possibility, but the process will be lengthy. However, even news that the committee has begun to study the topic could have immediate and significant consequences for markets, since the FOMC would be suggesting that it is considering changes to its reaction function that would result in higher average inflation over time.

Such a signal could cause the US dollar to weaken, the risk-free curve to steepen and TIPS-implied breakeven inflation to widen.

[1] The neutral, also natural or equilibrium, rate is the federal funds rate rate that neither speeds up nor slows down economic growth. Other interest rates tend to move fairly closely in line with the fed funds rate. FOMC decisions to raise or lower policy rates can be seen as signals of the health of the economy, policymaker concerns over inflation expectations, or both. The fed funds rate is a short-term interest rate. It is the rate that banks charge each other for overnight loans.

Steven Friedman

Senior Economist

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