The Fed’s Big Rethink on Monetary Policy
(Bloomberg Opinion) -- In his speech this week for the annual Jackson Hole conference, Federal Reserve Chairman Jerome Powell will talk about the central bank’s long-awaited review of monetary policy. Until recently, with the economy growing steadily, the challenge of coping with the next recession seemed almost academic. Now, with the U.S. mired in yet another sudden, severe and uniquely testing slowdown, the review takes on new gravity.
The Fed is grappling not just with the effects of the Covid-19 pandemic, but also with a change in the underlying economy. The problem is a persistent fall in the so-called neutral interest rate — the rate consistent with full employment and stable prices, as required by the central bank’s dual mandate. The lower this rate, the less room the Fed has to cut interest rates during a recession. Interest rates are quickly driven to their “effective lower bound,” and the central bank has to find other ways to provide monetary stimulus.
After the crash of 2008 and again this year, these methods have included bond-buying on an enormous scale — so-called quantitative easing — and new kinds of forward guidance to steer the economy’s expectations of future interest rates. Both innovations were necessary but both have limits. QE is subject to diminishing returns, and it pumps up asset prices (look at the stock market) in ways that could threaten financial stability. Forward guidance, on the other hand, works well only if people think the Fed can keep its promises. Despite strenuous efforts, it hasn’t been able to raise inflation to its 2% target since explicitly establishing that goal in 2012.
Various innovations have been discussed. One possibility is negative interest rates, but this might put banks under stress and the effect on households could be counterproductive (if, for instance, the policy encouraged people to spend less). Europe’s experience with slightly negative rates is far from compelling.
Another idea is to change forward guidance to tell investors that overshoots of future inflation will be tolerated or even deliberately engineered. This might take various forms — such as a commitment to maintain 2% inflation on average over a span of years, so that undershoots would require overshoots. Or the Fed could switch to a target for the level of future prices rather than the rate of inflation. This would have a similar effect, again requiring periods of higher-than-target catch-up inflation. The implicit promise in both cases is that interest rates would stay low for longer than the current approach dictates.
The question is credibility. How believable is it that, with the economy at full employment and inflation on target, the Fed would strive to push inflation still higher just because, at some earlier point, it said it would? The economic reasoning might be correct, but the politics would be difficult — and the Fed, though operationally independent, still has to explain itself to Congress and the public.
One way to overcome this difficulty, long recommended by many economists, would be for the Fed to express its goals in terms of nominal gross domestic product — that is, in terms of growth in demand. In effect, this would collapse the Fed’s dual mandate to one guiding metric combining changes in both prices and output. If demand grows more slowly than its target (of say 5% a year) the Fed would provide stimulus, regardless of whether the shortfall was due to lower output or lower inflation. This would make the promise of keeping interest rates low for longer more credible. Tolerating higher inflation, occasionally and within limits, would be baked into the formula.
The Fed might see an outright switch to targeting NGDP as too radical, but could take a useful step in this direction by making the measure more prominent in its analysis and public presentation. Other smaller changes would help as well. For instance, the Fed could refrain from issuing information that begs to be misunderstood — starting with its so-called dot plot of projected interest rates, which reliably causes more confusion than clarity.
The central bank’s recent performance has been impressive. Its review might improve monetary policy at the margin, and that’s certainly worth a try. But bear in mind that Powell and his team can do only so much. Effective macroeconomic management requires competent control of both fiscal policy and monetary policy. If the neutral rate of interest stays low, monetary policy becomes less effective no matter how well it’s conducted, so taxes and public spending must carry more of the burden of stabilizing the economy.
The economic-policy review the U.S. needs most concerns the budget — a major challenge for Congress and the next administration. Better monetary policy would be helpful, but without competent, responsive fiscal policy, this recession and the ones sure to follow will be deeper and more damaging than they should be.
Editorials are written by the Bloomberg Opinion editorial board.
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