How will the Federal Reserve revise its monetary policy framework in 2025?

The Federal Reserve’s “Statement on Longer-Run Goals and Monetary Policy Strategy”—commonly referred to as its monetary policy framework—is composed of guiding principles the central bank uses in setting and communicating policy. Since the Fed last updated this framework in 2020, the global economy has faced unique challenges: COVID-19 shutdowns, widespread supply chain issues, and multiple global wars. In 2025, the Fed Board will be tasked with reviewing the framework, identifying what has worked well and what hasn’t, and updating it accordingly. On this episode, David Wessel sits down with Brian Sack and Christina Romer, both former policymakers and authors of new research on the Fed framework’s successes and shortfalls.

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[music]

EBERLY: I’m Jan Eberly, the James R. and Helen D. Russell Professor of Finance at Northwestern University.

STEINSSON: And I’m Jón Steinsson, Chancellor’s Professor of Economics at the University of California, Berkeley.

EBERLY: We’re the coeditors of the Brookings Papers on Economic Activity, a semiannual academic conference and journal that pairs rigorous research with real time policy analysis to address the most urgent economic challenges of the day.

STEINSSON: And this is the Brookings Podcast on Economic Activity, where we share conversations with leading economists on the research they do and how it will affect economic policy.

EBERLY: This year the Federal Reserve will begin its five-year review of the monetary policy framework it adopted in 2020. At this year’s Brookings Papers on Economic Activity conference, we convened a small symposium to discuss the Fed’s framework ahead of that review—what’s working, what isn’t, what the Fed should consider revising, and what should remain the same.

Today’s episode of the BPEA podcast features an interview with two experts with intimate experience with the Fed framework: Brian Sack, former executive vice president of the Federal Reserve Bank of New York, and Christina Romer, former chair of the president’s Council of Economic Advisors, who presented new papers at that symposium. Today they are interviewed by David Wessel, director of Brookings’s Hutchins Center on Fiscal and Monetary Policy.

STEINSSON: The Fed initiated these regular reviews only five years ago, actually following a proposal that was raised and discussed in a 2018 BPEA paper titled, “Should the Fed Regularly Evaluate its Monetary Policy Framework?” The 2020 review resulted in some subtle but important changes to the framework which many have argued may have played a role in the bout of inflation we experienced post-COVID. Whether we should keep these new features or modify them is an important part of the discussion this time around.

Now let’s turn it over to David and hear his conversation with Brian and Christie.

WESSEL: Thank you, Jan and Jón. Christie, it’s good to be with you today.

ROMER: Nice to be with you.

WESSEL: And it’s good to be with you, Brian.

SACK: Thanks for having me.

WESSEL: So, Christie, let me start with you. The focus of this discussion at the Brookings Papers on Economic Activity was the Fed’s framework. When you look at the framework that the Fed adopted in August 2020, what do you think of it and what role does it play in the Fed’s slow response to the increase of inflation that was triggered by the COVID episode?

[2:50]

ROMER: Well, the framework that was reviewed before August 20th, and then they came out with a new one, had what we see is kind of at least four important changes from their previous framework. One was the introduction of what’s called flexible average inflation targeting, which is just simply the idea that the Fed says if inflation’s been running below our target for a while, we’ll have a period when inflation runs above our target. So, we’re on target on average. That was one change.

A second change that got a lot of notice was in terms of the second part of their mandate, maximum employment. One of the things that they’ve said is they would respond when employment was below maximum, but not when employment was above maximum unless there were some other problems.

And then two other changes that were more subtle, but in our paper, we argue are actually probably more important to the slow response to inflation are first, an elevation or a strengthening of the maximum employment goal. All the legislation says the Fed is supposed to head for maximum employment, but how they interpret it is obviously very important. And traditionally, the Fed has interpreted it as something closer to a normal level of employment or a sustainable level of employment. And the new framework really elevated that and had it much closer to something like we’re going to aim for a hot labor market, not just a sustainable, comfortable labor market.

And then the other subtle change was a move away really from preemption. This notion that the Fed is going to respond to what they see happening in the future rather than to just where inflation and employment are right now. And in our going through where did the slow response to inflation come from, we think it’s that elevation of the maximum employment goal to be in a hot labor market goal, and the moving away from having a very forward looking monetary policy.

WESSEL: Thanks, Christie. Brian, do you see it similarly? Are there other parts of the framework that you think are worth noting?

[5:12]

SACK: No, I see it largely similarly. I mean, first of all, I think the Fed should be commended for having done the review, taken a step back and asking what changes should it consider to its framework in order to meet its mandate. But I think in the end, they ended up with a set of changes that was probably geared too specifically to some of the challenges that they had been facing for the period since the global financial crisis. And those challenges were all involved sluggish economic growth, low inflation, and the constraints from the effect of lower bound. So, I think the framework changes that were made were too strongly geared in that direction.

And I guess I would add another element to it, like Christie said, which is there’s the changes that were actually made to the framework. And then there are also the decisions on implementing that framework with the tools that they have, those tools being guidance on the policy rate and asset purchases by the Fed.

And so, I think this framework review as we come to it again, needs to not just look at the changes that were made to the framework document that Christie was talking about, but also the decisions that were made to implement that framework.

WESSEL: Right. So, let me expand on that a little bit. So, you make a couple of points there. One of them was that this was basically a framework written after a period of below target inflation, which was adopted at the benefit of hindsight at exactly the wrong moment when suddenly we’re going to have an increase in inflation. So, you’re suggesting they were too much looking in the mirror.

But secondly, you made another good point, which is not only do they have a framework, but they implemented it by giving what economists call forward guidance, that is giving the markets advice about what they intend to do.

And in your paper, Brian, you call out the fact that in September 2020, a month after they announced the framework, they said that it would be appropriate to maintain a zero-interest rate until labor market conditions have reached levels consistent with their assessment of maximum employment. And, and in your slide, you underline the word “and,” inflation has risen to 2% and is on track to moderately exceed 2% for some time.

So, when I hear that, I think the guidance basically reinforced the gestalt of the framework, but it tied their hands even more. Is that the point you were trying to make?

[7:43]

SACK: Yes, I think the guidance was driven by the framework, was intended to deliver the objectives of the framework, but in its implementation made some mistakes in how that conditioning was laid out. In particular, you noted we underlined the word “and.” I think that that type of conditioning with that “and” clause proved to be problematic. So, it’s certainly good practice to condition your guidance about short rates on economic conditions. It’s been done in the past. It can be a very effective policy device to lay out the kind of conditions that you would need to see before lifting off from, say, the lower bound.

But in this case, by requiring both of those conditions to be met they, in my view, tied their hands too firmly and unnecessarily did so. And in particular, first of all, it’s already relatively aggressive to say we’re going to keep the policy rate at zero until we get inflation back to the target and the unemployment rate to full employment. So, even if you knew you were going to hit those conditions at the same point in time, that’s already a relatively aggressive policy because in most cases you would think when you get to those conditions, which are sort of like equilibrium conditions for the economy, the policy rate should be near its equilibrium level or its neutral level, which is typically above zero. So, that was aggressive to begin with.

But I think the real problem was this structure meant that both conditions had to be met. So, in circumstances where inflation was moving up rapidly and the full employment condition had not yet been met, this effectively tied the FOMC’s hands in a way that really didn’t put a bound on how far off track they could get in terms of having their policy rate respond to inflation.

We often talk about, in the academic research literature we talk about monetary policy rules, which are devices, formulas that describe how monetary policy is typically set for economic conditions. And those rules in many models deliver very good performance. So, it’s not that the central bank always follows a rule, but they give a nice reference point for thinking about good policy. And in the context of thinking about policy rules, basically this guidance allowed the deviation from the rule to be very large in size. So, the FOMC fell many percentage points below what the rule said policy should have been set at because of this form of the guidance that required both conditions to be met before liftoff.

WESSEL: Right. And, Christie, that that echoes some of the comments that you’ve made. You and your coauthor, David Romer, argue that the Fed’s desire to have a hot labor market, one in which unemployment is as low as possible and as many people as possible are working, and its unwillingness to act preemptively, as Brian described, contributed to the slow response to inflation. And in your paper, you put this in historical perspective, and I wonder if you can explain a bit the technique that you and David used to examine the Fed decision-making in the past and what conclusions you draw from it.

[11:04]

ROMER: Absolutely. So, first, I think it is important to discuss what do we mean when we say the Fed was slow to respond. And I think the basic facts are by March of 2021, inflation had already gone above the Fed’s 2% target. And what’s really striking is, as Brian’s been suggesting, is that they waited a full year until March of 2022 before we had the first rise in the funds rate. And so, that’s what we were trying to investigate in our papers—what role did that change in the framework perhaps play in that year-long wait to raise the funds rate.

And the method that we use is basically to listen to what policymakers said. So, we read the minutes of the FOMC meetings. We look at the speeches that the Fed chair, Jerome Powell, made, that vice chair of the FOMC and president of the Federal Reserve Bank of New York Don Williams made, to try to tease out what how they were interpreting their new framework, how it was influencing what they did. And so, what we do is to just read a lot and try to figure out what they were saying and what they were thinking.

And so, an example, remember, we said one of the things that the framework did was to elevate the maximum employment goal and strengthen it. How do we see that? Well, one is what Brian described in the forward guidance, that they said we want inflation up to our 2% target and we want employment at maximum. No idea that there might be a tradeoff between those two goals, or it might not be possible to have both those goals. So, they really were putting maximum employment right equal with their goals for inflation.

We also see, for example, Jerome Powell, the Fed chair, in his speeches talked about how important a really strong labor market is particularly for low- and moderate-income communities. Or we see John Williams, just right after they start to raise rates, say the labor market is “sizzling hot. We’re finally at maximum employment.” That’s how we figure out, you know, there’s been a change here in how they’re interpreting that maximum employment goal. So, I think that’s the technique that we use.

And as you mentioned, what we find is that that elevation of the maximum employment goal really did hold them back. They’re sitting there saying, boy, inflation is 5%, 7%. They know it’s high. They know it’s predicted to stay high for a while and they’re still holding back. And you hear them saying, but we’re not at our maximum employment goal, the labor market is not yet “sizzling hot.” And so, that’s how we do the forensic analysis of where did this slow response come from.

WESSEL: Brian, when you were speaking at the Brookings conference in September, we knew that inflation was already coming down. We seemed to be avoiding the recession that many of us expected. So, what do you think the costs were of this tardy response? Yes, we had a run up of inflation, but it came down as supply chains adjusted and it turned out that inflation expectations were well behaved. How big a mistake was this? What were the costs of that mistake, if you think it was one?

[14:40]

SACK: I think that’s a very good question and a good issue to consider as we think about reviewing this framework. I would argue that even if the FOMC has managed to pull off a soft landing, I think there’s two things to consider that suggests we shouldn’t just give a free pass to the framework or to the path of policy that we were on.

So, the first thing is, we’ve had a lot of overheating and a lot of inflation over this interim period. Now, you pointed to supply chains. And I think certainly some of that inflation was inevitable. Much of it wouldn’t have been avoided under a different policy path. But I do think this policy path with this slow response certainly added to the overheating we saw in the economy, certainly added to the inflation path we were on. By delaying liftoff, the Fed effectively created some of the most accommodative financial conditions we had seen in some time in the economy at a time when the economy was growing rapidly for other reasons and beginning to overheat. So, I do think it was a counterproductive path to be on even if it was subsequently corrected in a way that limited the ultimate damage.

The second point I would make is, going on that path and relying on the ability to correct the mistake later on is a riskier strategy. They had to raise rates very rapidly to restore their inflation credibility. That certainly risked a more dramatic slowdown in the economy. It creates more risk of financial accidents. We did have some financial stress, of course, in the banking sector. And it also created risks on inflation. And in the end, they were able to keep inflation expectations contained and bring inflation back down to date. But if inflation expectations had proven somewhat more fragile, it could have been even costlier.

So, I think a path that puts you so far from normal benchmarks for policy rules and then requires an aggressive correction is not an optimal path, and we shouldn’t give the framework a free pass just because we avoided the absolute worst outcomes.

WESSEL: Right. Right. In other words, it was a risk you don’t think they should take. And they got lucky. That’s the headline I put on what you just said.

SACK: It’s a risk they didn’t have to take. They got lucky, but they also, you know, I mean, they did correct. I think they, you know, deserve credit for realizing that as the tightening cycle got underway, they had to get more aggressive to achieve this outcome. But it was a riskier path than I think they had to be on.

[17:20]

ROMER: Let me just add one thing, David, which is that I agree with everything that Brian said, but there’s also just this other element that people really hate inflation. We’ve been through such a long period where inflation has been low. I think we policymakers may have forgotten just how much people really dislike inflation, even if their wages are going up at the same rate, they still … it just is a visceral response.

And now we see, right, inflation’s low, but all people are noticing is, yeah, but the price of eggs is still not back down to where it was in 2019 or 2020. And so, we don’t want to lose sight of just that it makes people really unhappy, and it may affect how they view the economy, how they vote, their expectations, and spending. So, we need to realize that going through a year of quite high inflation may have had important consequences.

WESSEL: Yeah, that’s a very good point. So, the Fed is sitting down now to begin this review of the framework. I know for a fact that they have read your papers and listened to the discussion because one of the Fed governors mentioned it to me. So, Christie, let me start with you. What should they do differently? What should they change? And what should they keep the same?

[18:42]

ROMER: There are a couple things I wanted to echo from Brian’s comments. Which one is just the Fed does deserve a lot of credit, both for having a framework review back in 2019 and 2020 because it’s just good policymaking to look at what you’ve done, what’s gone right, what’s gone wrong, and see if you want to change it. And I think it’s great that they’re doing this again. And the fact that they’re reading what academics and people in markets are saying, I think is really valuable.

I also want to echo, I think Brian hit the nail just right on the head when he said the problem with the last framework review is that it was somewhat too tied to the mistakes that they’d just made, to sort of what had been going wrong after the financial crisis and the Great Recession. And so, they came up with a framework that would deal with that problem maybe quite well but was not robust when they were suddenly hit with a very different problem, which is a pandemic and a bunch of post-pandemic inflation.

So, the big picture as they go on to the review is to say, let’s get something more robust, more general and able to take into account a wider range of things that they might face. And in doing this, I think our point of view is, you know, the flexible average inflation targeting is not a bad idea. The notion that we may be at the effective lower bound on interest rates more often, going forward we may find ourselves with sometimes inflation being too low and maybe not as many tools as we’d like to deal with it, to say, let’s have a policy that will take care of that. And so, I think the average inflation targeting is not a bad idea.

And then in terms of things to change, since we do see this trying to elevate the maximum employment goal to something closer to a hot labor market, I think it’s just not a sensible strategy. That a crucial fact is that monetary policy can’t solve every problem. And it is a very poor tool for dealing with very important issues like inequality and lack of opportunity for many communities and things like that. Those are real problems. It is unfortunately not problems that monetary policy is very good at dealing with. Those are problems that you need Congress and the president to come up with policies that are really going to be effective.

[21:17]

And the best thing that monetary policy can do is keep inflation low and keep the economy growing at that normal, sustainable level. And so, I would recommend going back to the older interpretation of maximum employment is that that sustainable, comfortable level of the economy.

Likewise, I think we’re going to want to respond to deviations from maximum both above and below. One of the things that we do in the paper is just to look back at history, going back to World War II, and saying those times when the Fed did let the labor market get hot, how did it work out? And in all of the cases, something went wrong. Either it was inflation, that’s what usually happened, or sometimes it shows up in a bubble and bust in financial markets. And so, the Fed really, I think, would be well-served by having a more sustainable notion of maximum employment.

WESSEL: I guess the people who take the other side of this argument would basically say that for a long time the Fed was tighter than necessary, that they thought that inflation was very sensitive to unemployment, and it turned out not to be that sensitive. And that’s the lesson they drew from the post-global financial crisis period. And so, they think that the Fed was systematically too tight. And you’re saying, yeah, that’s not the way you read the history.

[22:46]

ROMER: Well, there were real problems with policy coming out of the Great Recession. I think policy was often too tight. But the answer to that is to not say, so what we’re going to do is aim for a much hotter economy; is to say, why did we make that mistake? Why did we not do enough after the Great Recession? And that really comes to this notion that they need to keep doing preemption, they need to keep looking forward because monetary policy affects the economy a very long way.

But in a case like after the Great Recession, where they kept their forecasts, kept being very wrong, the answer is not to throw away the forecast. It’s to say, what did we do wrong and how do we get better forecasts and how do we have a better read on where the economy’s headed?

So, I think that the right message for the framework is keeping forward looking, have a sensible estimate of what maximum employment is, but then do a really good job and invest, put a lot of resources into making a very good projection of where the economy is headed.

WESSEL: So, Brian, what would you do if you were at the pen rewriting the framework?

[24:00]

SACK: I think I agree with Christie in almost every way. I think the framework document itself should be more what we call a constitutional. It should provide a structure for effective policymaking that applies to a wide range of economic circumstances. It’s not tailored to the one particular circumstance that that’s been in place. And so, for me, in terms of the current framework document, that would mean going back and reversing the change that was made on shortfalls. I think this idea of only responding to shortfalls to full employment as opposed to deviations was very asymmetric and very aimed at those particular circumstances.

WESSEL: Let me just interrupt you to just explain what that you mean is the Fed framework basically said when unemployment is high, we’re going to react aggressively. And when it’s low, we’re going to not react aggressively.

SACK: Yes, exactly. So, I think I would just take that out of the framework document. I think it’s too specific and it’s too problematic in some circumstances to be in the framework document.

In terms of the other large asymmetry or change in the framework document, the average inflation targeting, I’m a bit more against average inflation targeting than I think Christie is. It’s a bit of a different argument. I don’t think it’s problematic necessarily. I just think it’s not that far from just flexible inflation targeting. And the averaging part was vague enough in the framework that I don’t think it’s actually helping a great deal. So, I don’t think it’s problematic to keep it. But on the other hand, I just don’t think it’s that that beneficial. So, I would basically remove both of those pieces and just have the framework document focus on a set of principles that I think are very robust across economic circumstances.

And then as I mentioned towards the beginning, I would also in the review very carefully look at the implementation. We talked a lot about the guidance. So, I think the lesson on the guidance is make sure you’re conditioning on economic variables in a robust and effective manner.

And we didn’t touch on QE [quantitative easing], which is the other tool. And I think there’s also lessons to be drawn on QE. I think on QE, it’s very important for them—the QE is the asset purchases that the Fed conducts to help support financial conditions—I think it’s very important to hold QE to the same type of standards that we hold the main policy instrument to in terms of, let’s make sure it’s calibrated appropriately for the economy. Let’s make sure we communicate clearly about QE. And let’s make sure its purpose is clear, whether it’s aimed at market functioning purposes or just broad policy accommodation. I know I’m touching on some things we didn’t actually get to, but I think these should be important pieces of the framework review as the Fed gets to it.

WESSEL: Finally, let me pick up on that final question about Fed communications, which supposedly is part of the review, although the last time they kind of ducked it. Christie, in your paper you said you guys should use forward guidance much more sparingly. Like, I think what you were saying is when you have a clear message, like they did during the global financial crisis, that we’re going to keep rates at zero for a long time, so don’t panic when the economy picks up. That’s useful then. But at other times they can just tie their hands.

And I’m curious, okay, but what would you do about the famous dot plot, the quarterly report at which the 19 members of the Federal Open Market Committee give their prediction for what will happen to short-term rates under some conditions that are not really very well explained? Would you keep it or do away with it?

[27:41]

ROMER: Well, let me first just reiterate, there are times when forward guidance is useful. I think what our perspective is, is that if the Fed states very clearly what their goals are and they make it very clear they’re going to use all of their tools, not just the interest rate but as Brian mentioned asset purchases or communications, then at some level saying and here’s you know, what we’re going to do to the funds rate for this period is in some ways overkill. And that it can often constrain them because we already have two tools that we can use to stabilize the economy. We have fiscal policy; we have monetary policy. Fiscal policy is inherently slow. You’ve got to get an act through Congress, that can take a really long time. So, it’s really valuable to have a tool that can respond to quickly.

And one of the things that forward guidance does is the Fed kind of gets locked in. And we saw this when interest rate or when inflation was going up, the Fed was really hesitant to change as they made this forward guidance. And they don’t want to surprise financial markets. So, that’s kind of what’s behind our thought that don’t just routinely use forward guidance. Save it for when you really need another communications tool.

On the dot plots, again it’s useful to have transparency and Fed policymakers to say where they think the economy’s headed. The trouble with them making a where they say they think the funds rate is headed is people focus in on that in a very counterproductive way. Right? They say what’s the dot in the middle? That’s where the Fed’s going to be. Well, it’s not. There are 19 people on that committee and there’s sometimes a huge range and sometimes there’s a little range.

And so, I think often the dot plots just end up confusing people because of the way they’re either reported or interpreted by a lot of people out there in the economy. So, it’s not a hill I’m going to die on—let’s get rid of those. But I think they can cause problems.

WESSEL: Okay, Brian, defend the dot.

[29:53]

SACK: I’d be very sad if the dot’s going away. Well, first of all, let me say that, I mean, I think the Fed and other central banks they’re in the business of communicating about their policy path. It’s really unavoidable. So, to Christie’s point, there are times when you want to turn it up with explicit guidance and maybe those times you say for the right circumstances and when you’re stuck at the effective lower bound, those are certainly circumstances where that’s productive. But at other times, you’re still communicating about at least your expected path for policy. And that’s really what the dot plot provides as well. So, I think the dot plot’s an important part of that.

And I would argue it’s a highly effective part of that. It’s not perfect, but it’s pretty effective. And the reason is it’s quantitative, whereas we get an FOMC statement that’s qualitative and descriptive, but the dot plot and the whole SEP [Summary of Economic Projections] forecast gives you that quantitative reading on explicitly about what FOMC members are seeing for the economy. And then by tying that with the dots, it gives you a lot of information about their reaction function and their policy intentions.

So, I think it’s a very important communication device for the markets. And I don’t think the markets just oversimplify and take it on board. I think markets understand these are forecasts that won’t necessarily come true. They understand that there’s a variety of views. They understand that they may want to weight different views differently. So, to me, it’s a piece of information that gets used pretty efficiently by the markets and helps policy be effective.

WESSEL: Well, great. I’m glad that by the end of the conversation, I found something in which you’re not in furious agreement.

[music]

Brian Sack and Christie Romer, thanks very much for your time and for the work you put into these papers, because I know that they’re having influence on policymakers as they try and do better next time.

ROMER: Well thanks, David. Thanks, Brian. It was nice to have the conversation.

SACK: Thank you, David. Great to talk to you today.

STEINSSON: Once again, I’m Jón Steinsson.

EBERLY: And I’m Jan Eberly.

STEINSSON: And this has been season 5 of the Brookings Podcast on Economic Activity. Thanks to our guests for this great conversation, as well as a big thanks to all of the BPEA authors and Brookings experts who joined the podcast this season. Be sure to subscribe to get notifications when we launch season 6, which will be in April 2025.

EBERLY: The Brookings Podcast on Economic Activity is produced by the Brookings Podcast Network. Learn more about this and our other podcasts at Brookings dot edu slash podcasts. Send feedback to podcasts at Brookings dot edu, and find out more about the Brookings Papers on Economic Activity online at Brookings dot edu slash B P E A.

STEINSSON: Thanks to the team that makes this podcast possible, including Kuwilileni Hauwanga, supervising producer; co-producers Fred Dews and Chris Miller; audio engineer Gastón Reboredo; show art was designed by Katie Merris at Brookings; and promotional support comes from our colleagues in Brookings Communications.