Monetary policy in the future

I delivered the following remarks at the IMF’s Rethinking Macro Policy III conference on April 15, 2015.

Thanks to the International Monetary Fund for inviting me to participate in this panel on “Monetary Policy in the Future.” In the few minutes I have I’ll offer some thoughts on the Fed’s monetary policy framework, its tools for implementing monetary policy, and how both are likely to evolve as we return to a more historically normal economic and policy environment.

In January 2012 the Federal Open Market Committee (FOMC) issued for the first time a formal description of its policy framework, which has been re-approved each January since then.1 The framework document emphasizes the FOMC’s commitment to a balanced approach in the pursuit of the Fed’s two statutory objectives, price stability and maximum employment. The FOMC has given the public extensive guidance about how it defines those objectives, setting a symmetrical inflation target of 2 percent and reporting each quarter FOMC participants’ estimates of the sustainable rate of unemployment. This policy framework is backed by substantial explanation and analysis, via the chairman’s press conferences, FOMC meeting minutes, FOMC economic projections (including projections of the federal funds rate), testimony, and speeches.

The FOMC’s policy framework corresponds to what Lars Svensson has called a targeting rule (see my 2004 speech, “The Logic of Monetary Policy” for further discussion). In a targets-based framework, the central bank forecasts its goal variables—inflation and employment, in the case of the Fed—and describes its policy strategy for bringing the forecasts in line with its stated objectives. Although targeting rules are not mechanical, they do provide a transparent framework that, importantly, is robust to changes in the structure of the economy or the effectiveness of monetary policy, so long as those changes can be incorporated into forecasts. Targeting rules also conform to the basic economic dictum that principals (in this case, Congress and the public) are better off monitoring their agents’ outputs (in the case of the FOMC, the outcomes of policy choices) rather than their inputs (the specific settings of policy instruments).

The policy framework has improved the FOMC’s communication, I believe. Today, for example, the Fed’s commitment to 2 percent inflation is providing the public useful information about the FOMC’s likely approach to policy in the year ahead. Moreover, the anchoring of inflation expectations that began under Volcker and Greenspan, and which I believe was further strengthened by the setting of a numerical definition of price stability, gave the Fed more scope to ease monetary policy in response to the Great Recession than it otherwise would have had.

Of course, no policy framework is without drawbacks, as attested by the difficulties the FOMC has faced in dealing with the zero lower bound on interest rates. If the Committee were to contemplate changing its framework, there are two directions it might consider.

The first would be to adopt what Svensson called an instrument rule, which specifies how the policy instrument, in the Fed’s case the federal funds rate, will be set as a relatively simple function of a few variables. I am perfectly fine using such rules as one of many guides for thinking about policy, and I agree that policy should be as transparent and systematic as possible. But I am also sure that, in a complex, ever-changing economy, monetary policymaking cannot be trusted to a simple instrument rule. I was going to elaborate on this point, but I found a nice statement of the argument in a classic piece of research, which I’ll quote in its entirety:

“Even with many such modifications, it is difficult to see how…algebraic policy rules could be sufficiently encompassing. For example, interpreting whether a rise in the price level is temporary or permanent is likely to require looking at several measures of prices (such as the consumer price index, the producer price index, or the employment cost index). Looking at expectations of inflation as measured by futures markets, the term structure of interest rates, surveys, or forecasts from other analysts is also likely to be helpful. Interpreting the level and the growth rate of the economy’s potential output—which frequently is a factor in policy rules—involves predictions about productivity, labor-force participation, and changes in the natural rate of unemployment. While the analysis of these issues can be aided by quantitative methods, it is difficult to formulate them into a precise algebraic formula. Moreover, there will be episodes where monetary policy will need to be adjusted to deal with special factors. For example, the Federal Reserve provided additional reserves to the banking system after the stock-market break of October 19, 1987 and helped to prevent a contraction of liquidity and to restore confidence. The Fed would need more than a simple policy rule as a guide in such cases.”

As some will have guessed, the quote is from John Taylor’s classic 1993 paper introducing the Taylor rule, “Discretion versus Policy Rules in Practice” (pp. 196-7).

The second possible direction of change for the monetary policy framework would be to keep the targets-based approach that I favor, but to change the target. Suggestions that have been made include raising the inflation target, targeting the price level, or targeting some function of nominal GDP. Some of these approaches have the advantage of helping deal with the zero-lower-bound problem, at least in principle. My colleagues at the Fed and I spent a good deal of time during the period after the financial crisis considering these and other alternatives, and I think I am familiar with the relevant theoretical arguments. Although we did not adopt one of these alternatives, I will say that I don’t see anything magical about targeting two percent inflation. My advocacy of inflation targets as an academic and Fed governor was based much more on the transparency and communication advantages of the approach and not as much on the specific choice of target. Continued research on alternative intermediate targets for monetary policy would certainly be worthwhile.

That said, I want to raise a few practical concerns about the feasibility of changing the FOMC’s target, at least in the near term. First, whatever its strengths and weaknesses, the current policy framework, with its two explicit targets and balanced approach, has the advantage of being closely and transparently connected to the Fed’s mandate from Congress to promote price stability and maximum employment. It may be that having the Fed target other variables could lead to better results, but the linkages are complex and indirect, and there would be times when the pursuit of an alternative intermediate target might appear inconsistent with the mandate. For example, any of the leading alternative approaches could involve the Fed aiming for a relatively high inflation rate at times. Explaining the consistency of that with the statutory objective of price stability would be a communications challenge, and concerns about the public or congressional reaction would reduce the credibility of the FOMC’s commitment to the alternative target.

Second, proponents of alternative targets have to accept the fact that, for better or worse, we are not starting with a blank slate. For several decades now, the Fed and other central banks have worked to anchor inflation expectations in the vicinity of 2 percent and to explain the associated policy approach. A change in target would face the hurdles of re-anchoring expectations and re-establishing long-term credibility, even though the very fact that the target is being changed could sow some doubts. At a minimum, Congress would have to be consulted and broad buy-in would have to be achieved.

Finally, a principal motivation that proponents offer for changing the monetary policy target is to deal more effectively with the zero lower bound on interest rates. But economically, it would be preferable to have more proactive fiscal policies and a more balanced monetary-fiscal mix when interest rates are close to zero. Greater reliance on fiscal policy would probably give better results, and would certainly be easier to explain, than changing the target for monetary policy. I think though that the probability of getting Congress to accept larger automatic stabilizers and the probability of their endorsing an alternative intermediate target for monetary policy are equally low.

A few words on policy tools: The depth of the Great Recession, together with the zero lower bound on interest rates, forced the Fed to devise new tools to make monetary policy more accommodative, including large-scale asset purchases and communication about the contingent future path of rates. Under more historically normal circumstances, when the zero lower bound is no longer a constraint, I expect that these tools will go back on the shelf. The operating instrument will once again be the federal funds rate and the communications framework will be the targets-oriented policy framework I described earlier. Importantly, the return to the use of the federal funds rate as the main policy instrument should be feasible even if the Fed’s balance sheet remains quite large for a time. Although reserves in the banking system are not expected to return to pre-crisis levels for some years, the Fed has a number of instruments—including its authority to pay interest to banks on their excess reserves, as well as the ability to offer reverse repurchase agreements that effectively allow nonbanks to deposit at the Fed at a fixed interest rate—that should allow it to manage short-term interest rates effectively (see here and here for further discussion). Concerns about unwinding quantitative easing are therefore misplaced, in that the Fed’s ability to tighten monetary policy at the appropriate time will not require that it sell assets or rapidly reduce the size of its balance sheet. To the extent that the large balance sheet has some residual effect on longer-term yields, the effects on the economy can be compensated for by changes in the federal funds rate.

The FOMC has indicated that it intends to let the Fed’s portfolio run off over time, so that excess reserves in the banking system eventually return to levels comparable to those before the crisis. Of course, I have not been privy to the internal discussions, having left the Fed more than fourteen months ago, but I wonder if the case for keeping the balance sheet somewhat larger than before the crisis has been adequately explored. As I mentioned, a larger balance sheet should not affect the ability of the FOMC to change the stance of monetary policy as needed. Indeed, most other major central banks have permanently large balance sheets and are able to implement monetary policy without problems. Moreover, the fed funds market is small and idiosyncratic. Monetary control might be more, rather than less, effective if the Fed changed its operating instrument to the repo rate or another money market rate and managed that rate by its settings of the interest rate paid on excess reserves and the overnight reverse repo rate, analogous to the procedures used by other central banks.

Another potential advantage of a large balance sheet is that it facilitates the creation of an elastically supplied, safe, short-term asset for the private sector, in a world in which such assets seem to be in short supply. On the margin, the Fed’s balance sheet is financed by bank reserves and by reverse repos, which can be thought of as reserves held at the Fed by nonbank institutions. From the private sector’s point of view, Fed liabilities are safe, overnight assets that could be useful for cash management or as a form of reserve liquidity. In a system of so-called full allotments, these assets would be supplied by the Fed at a fixed interest rate. The Federal Reserve was created, in part, to provide “an elastic currency,” so this provision of a liquid asset at a fixed rate seems consistent with the central bank’s mission.

The principal objection to a permanently large balance sheet financed in part by a reverse repo program appears to be a concern about financial stability. The worry is that the availability of reverse repos would facilitate runs. For example, in a period of stress, money market funds might dump commercial paper in favor of Fed liabilities. I take that concern seriously but offer a few observations. First, the overall increase in liquidity in the financial system that would be the result of a larger Fed balance sheet would probably itself be a stabilizing factor, so that the net effect on stability is uncertain. Second, if private-sector entities ran to Fed liabilities, there are actions the Fed could take after the fact to mitigate the problem, including not only capping access to reverse repos but also recycling liquidity, for example, by increasing lending to banks (through the discount window) or to dealers (through repo operations). Finally, runs can occur even in the absence of a reverse repo program, as we saw during the crisis. Regulatory action to minimize the risk of or incentives for runs would seem to be the more direct way to deal with the issue. Put another way, if runs really are a major concern, getting rid of the Fed’s repo program alone seems an inadequate response.

To be clear, I am not making a recommendation today about the ultimate size of the Fed’s balance sheet. It’s a complex issue that deserves more discussion. My aim today is to contribute to that discussion and encourage further public debate.

1. The January 2012 framework in turn built on earlier FOMC communication. An important step toward greater transparency was the fall 2007 inclusion of three-year-ahead forecasts of inflation and unemployment in the Committee’s quarterly economic projections. As FOMC participants’ projections assume optimal monetary policy, and because three years is normally enough time for monetary policy actions to have their full effects, the long-term projections were appropriately interpreted by the public as policy targets rather than as literal forecasts. 

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