The long-awaited outcome of the Federal Reserve’s monetary strategy review is finally out. This column argues that while the ‘Powell doctrine’ responds to a genuine need to address issues in the Fed’s policy framework, it also introduces complexities in the interpretation and implementation of monetary policy which are likely to become more apparent over time. The hurdles involved do not have easy solutions, and other central banks pondering their own monetary policy framework are well advised to take heed.
The long-awaited outcome of the Fed’s monetary strategy review is finally out. The announcement took the form, on 27 August, of a speech by Chairman Jerome Powell,1 delivered online at the annual Jackson Hole conference and a ‘consensus statement’2 by the Federal Open Market Committee (FOMC) providing information on the long-run goals of monetary policy. These documents are important not only because they help understand the future US monetary policy, but also because they may provide inspiration to the ECB, which has started a similar review. It is thus worthwhile looking at them in some detail.
One must appreciate the Fed’s rather uncomfortable position. On the one hand, it felt compelled to act: its analysis suggests that changes in the functioning of the US economy – more on which below – require adjustments in its monetary framework to continue fulfilling the central bank’s dual mandate of “maximum employment” and “price stability”. All in all, these changes support a more expansionary stance, with greater emphasis placed on the “maximum employment” leg of the mandate. On the other hand, the Fed has been reluctant to adopt new instruments, for example bringing interest rates below zero as has been done by other central banks. This narrows the range of available options. To make things worse, since 2017 the Fed has been under heavy political pressure to pursue a more expansionary stance from a muscular administration which has repeatedly shown that it considers the independence of its central bank irrelevant, if not a nuisance. A more accommodative stance in these conditions could, regardless of the good arguments supporting it, be interpreted as subservience to politics and entail a reputational loss.
In a nutshell, two changes in the US economy triggered the review. First, the outstanding performance of the labour market in the years before Covid-19 – with low and declining unemployment, increasing employment, and narrowing differentials across segments within the labour force – did not lead to higher inflation, contrary to what past regularities suggested. The Phillips curve appears to have flattened. Second, empirical estimates indicate that ‘r-star’ – the conjectural interest rate at which the economy operates at full employment and with stable inflation – has declined, bringing the whole spectrum of interest rates down. Meanwhile, average inflation has edged below the Fed’s target of 2%, falling below that level in downturns but not rising above it in upswings. The Fed is concerned that, as a result, inflationary expectations may ‘un-anchor’, i.e. fall persistently below 2%, bringing down interest rates further until they reach the ‘effective lower bound’ at which conventional monetary instruments become powerless. A deflationary spiral may ensue.
To some extent, the announcements of 27 August were expected. It was widely foreseen, for example, that the direction of the move would be expansionary, and it was also understood that the Fed would refrain from introducing new unconventional instruments. A sense of déjà vu may explain why the immediate market reaction was lukewarm. After some volatility, long-date yields and the dollar were little moved; if anything, they moved opposite to what more monetary accommodation would imply. This matters little, though. Policy moves should not be judged on the short-term reaction of financial markets, contrary to regular practice among watchers and communication experts. Strategic policy decisions, such as this one, are digested slowly and produce an effect over time.
The aforementioned rationale for the review raises some conceptual issues. First, the concern that past inflation shortfalls may affect expectations presupposes that expectations are backward-looking, but there is little evidence of this. Recent pre-Covid estimates show that the inflationary expectations are not reacting significantly to lagged inflation (Blanchard 2016). The Fed’s preferred measures of expected inflation were well-anchored at 2% until late 2019 (Federal Reserve Bank of Philadelphia 2019). Moreover, while headline inflation did indeed fall below 2% at times, the trimmed-mean measure of core inflation3 (the best gauge of underlying inflationary forces, according to some) remained remarkably stable at 2%. The second implicit tenet is that inflationary expectations drive actual inflation. While there is some econometric support for this (Blanchard 2016), other evidence suggests caution. Consultations4 conducted by the Fed with representatives from the ‘real economy’ (local communities, small financial institutions, entrepreneurial leaders and so on) provide interesting insights in this respect. At no point did those representatives indicate that “inflation” (the variation over time of a general price index) or its “expectation” (future anticipated changes in it) played any role in their opinions, concerns or actions. What matters to them – notably making them unhappy – is whether the specific prices they are interested in (health expenses, energy costs, mortgage charges, basic consumer prices of goods bought regularly, labour or input costs for entrepreneurs) increase. Little else seems to get noticed.
The first and most evident novelty is that the Fed will now aim at its 2% inflation goal no longer as a point target, but on average over a period of time (presumably, several years). This implies that if inflation remains below 2% for a while, the Fed will want to ‘make-up’ for the shortfall by allowing inflation to be higher than 2% for a subsequent period (also of unspecified length). The new formulation also embodies a different approach towards “maximum employment”. A passage in the FOMC statement5 is worth reproducing fully: “In setting monetary policy, the Committee seeks over time to mitigate shortfalls of employment from the Committee’s assessment of its maximum level and deviations of inflation from its longer-run goal.” Shortfalls of employment are corrected, excesses are not; this makes the Fed’s policy approach asymmetric. This also marks the abandonment of the Phillips curve as a reliable policy trade-off, a notion elaborated further by other FOMC members.6 Taken literally, that passage also seems to imply that observed deviations of inflation from target will be corrected, not forecasts of such deviations. Another victim of the Powell doctrine therefore is inflation targeting, as commonly intended, which requires the central bank to adjust instruments in order to target its own forecasts of future inflation.
The new formulation also raises concrete policy dilemmas which are likely to become more apparent over time. Who, or what, will bring inflation up to the level above 2% which the Fed now pledges to attain? No new instruments were introduced, so the operational recipe of the review is ‘more of the same’: more forward guidance, more asset purchases, possibly in combination with more implicit or explicit monetary-fiscal coordination. This makes the realism of the announced goal questionable, if, as many believe, inflation has become less controllable in recent years. In a recent co-authored book (Goodhart and Pradhan 2020), Charles Goodhart argues that inflation has been anchored down by global demographic factors and trade patterns. Against these influences, central banks – especially if acting in isolation – can do little. Goodhart predicts that these factors will reverse, and that inflation will rise again as globalisation recedes amidst political opposition fuelled by inequality, health and other concerns. If that happens, the wish of the Fed and other central banks may be fulfilled, and the risks of deflation would recede. In that case, however, the new ‘doctrine’ announced by Powell would become unnecessary and would probably be abandoned; in economic terms, it is not ‘time consistent’. If Goodhart’s prediction is not borne out, on the other hand, Powell’s pledge to raise inflation may remain unfulfilled and the Fed risks losing credibility for a different reason.
It is also noteworthy that neither Powell nor the FOMC statement emphasise financial stability risks. In his speech, the Fed chair gave a clean bill of health to the US economy pre-Covid, including explicitly the solidity and resilience of the financial sector. The exuberance of the stock market and the rapid increase of leveraged and risky loans by the banking sector, both of which many observers attribute to excessive supply of liquidity, play no role in the new ‘doctrine’. Again, the future will tell. Should financial instability return as some predict, the Powell 2020 doctrine may end up being likened by historians to the Fed’s complacency during the years of the now defunct Great Moderation.
To sum up, the Powell doctrine responds to a genuine need to address issues in the Fed’s policy framework, but also introduces complexities in the interpretation and implementation of monetary policy which are likely to become more apparent over time. The hurdles involved do not have easy solutions, stemming in part from complex and little-understood changes which are taking place in our market economies as part of a globalized world. Whether the doctrine will facilitate the task of the Fed going forward is an open question. Other central banks pondering their own monetary policy framework are well advised to take heed.