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Fed should be sure to include monetary policy tools in forthcoming framework review

A general view of the U.S. Federal Reserve Board of Governors' seal at the William McChesney Martin Jr. Building, in Washington, D.C., on Thursday, October 3, 2024. (Graeme Sloan/Sipa USA)
Graeme Sloan/Sipa USA via Reuters Connect

When Federal Reserve Chair Jerome Powell kicked off the promised every-five-year review of the Fed’s “monetary policy strategy, tools, and communications” at the annual Jackson Hole conference in August 2024, he noted “…that the pandemic economy has proved to be unlike any other, and that there remains much to be learned from this extraordinary period.” He acknowledged that “the limits of our knowledge—so clearly evident during the pandemic—demand humility and a questioning spirit focused on learning lessons from the past and applying them flexibly to our current challenges.”

In November 2024, the Fed said this year’s review would be “focused on two specific areas: the Federal Open Market Committee’s Statement on Longer-Run Goals and Monetary Policy Strategy, which articulates the Committee’s approach to monetary policy; and the Committee’s policy communications tools” (emphasis added).

In my view, the “questioning spirit focused on learning lessons from the past” also should infuse an examination of the tools piece of strategy, tools, and communications. In particular, the FOMC should look at the lessons learned from the way it employed the unconventional tools of forward guidance on the path of interest rates and asset purchases and of asset purchases themselves once interest rates had been reduced to zero in March 2020.   

A number of questions have been raised about the forward guidance used in the post-COVID period. In a working paper in 2023 on the role of monetary policy in the inflation surge, my co-author, Gauti Eggertsson, and I ascribed much of the delay in responding to high inflation in 2021 to the forward guidance the FOMC gave.

On interest rates, it said it would keep nominal rates at zero until the labor market was at full employment and inflation was at its 2% target and on track to “moderately exceed [that rate] for some time.” In their commentary on this forward guidance, FOMC members emphasized the “and”—that rates would not be raised until both the employment and inflation criteria were met. This guidance was poorly designed as it did not account for a scenario in which inflation would substantially overshoot the price stability target before the FOMC was certain that employment had reached its maximum. To be sure, the FOMC included an escape clause in its policy announcements through this period: “The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals.” Yet activating that clause did not appear to get thorough consideration by the FOMC, even as inflation ranged far above its target. 

Speaking at Brookings, Powell recognized the problems with the dual criteria under the circumstances that developed, saying “I don’t think I would do that again.” Furthermore, that commitment guaranteed that real interest rates would be deeply negative at full employment, implying an overshoot of the full employment goal and heightened inflation pressure.

The FOMC’s forward guidance on ending its substantial volume of asset purchases and the sequencing of stopping asset purchases before raising rates also imparted inertia to policy tightening. The FOMC said it wouldn’t begin to taper its purchases until “substantial further progress” had been made toward its goals; it would give plenty of warning before it began to scale back purchases; and it would not raise rates until it was no longer buying securities, despite the fact that it is the expected volume of purchases rather than the actual purchases that affects financial conditions.

It seems likely that forward guidance delayed interest rate lift-off by at least several months and maybe as much as half a year. To be sure, most of the inflation early in the COVID recovery period resulted from supply disruptions that the FOMC and most economists expected to fade quickly once vaccines became available. But by fall 2021, it became clear that excess demand was playing an important role, and the sooner action had been taken to restrain demand, the sooner inflation would have begun to abate. 

I draw a number of lessons from this experience:

  • Forward guidance is a valuable tool to shape expectations when policy rates are pinned at zero.
  • When it is used, it should be conditions-based, as it was, not calendar-based.
  • Flexibility to respond to unexpected developments needs to be firmly embedded in forward guidance, even at the expense of specificity that could make it more effective initially—and then exercised when the unexpected occurs.
  • Forward guidance should not sacrifice one arm of the dual mandate (in this case, stable prices) for the other (maximum employment).
  • Guidance should be designed to sustain price and economic stability after rates lift off.

Turning to the Fed’s asset purchases or quantitative easing (QE), recall that those started with efforts to counter financial market instability as COVID shut down the global economy. As markets stabilized, the purpose gradually shifted toward the monetary policy goal of reducing interest rates to stimulate spending. The pace of purchases was dialed back in the transition, but it remained relatively high—considerably higher than in the comparable open-ended QE3 regime of 2012-14. And purchases persisted well into the high inflation period of mid- to late-2021. Moreover, they continued to include a substantial quantity of mortgage-backed securities even as the residential real estate market was booming, with house prices rising rapidly. 

This experience raises a number of questions. How was the shift in objectives made, and by whom? Was the composition of the purchases—long- relative to short-term Treasury paper, and Treasury relative to mortgage-backed securities—well suited to the new purpose? How was the size determined; were the beneficial effects proportional to the larger size? The purchases added considerable interest rate risk to the Fed’s portfolio—indeed they work by taking duration out of the market and onto the Fed’s balance sheet in order to reduce relevant market interest rates facing borrowers. But the interest rate risks are ultimately borne by the taxpayers in the form of lower and more volatile remittances by the Federal Reserve to the Treasury as interest rates rise. Should this be a consideration in shaping the size and composition of purchases? Purchases increase bank reserves, and some have hypothesized that the higher level of liquidity has persistent effects on bank behavior so that reserves cannot safely be reduced back to where they were before QE. (See, for example, this paper presented at the Jackson Hole conference in 2022.) The result is said to be a ratcheting higher of the Fed’s balance sheet after every round of QE. Is this the case, and does a permanently higher trajectory for reserves and the Fed’s balance sheet have public policy implications that should be factored into QE decisions? 

The Fed was fully justified in activating forward guidance and asset purchases—used so effectively during the Global Financial Crisis of 2008-9—to help the economy recover from the effects of COVID.

Now it’s important for the FOMC to say what lessons it has learned from this experience. An open and thorough evaluation of recent experience with unconventional policy tools by this FOMC will provide valuable guidance to future FOMCs that might find themselves in comparable situations. The FOMC should consult publicly and widely and apply “a questioning spirit focused on learning lessons from the past” to its use of tools as well as to strategy and communications. 

Author

  • Acknowledgements and disclosures

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