The Hutchins Center Explains: The framework for monetary policy

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Editor's note:

Want to learn more? The Hutchins Center will host a public event on January 8 to explore the debate on keeping or changing the 2 percent inflation target. Register for the webcast or to attend in person.

What is the Federal Reserve’s mandate? Since 1977, Congress has charged the Fed with pursuing “maximum employment” and “stable prices.” The definition of those terms is left to the Fed. Here’s a look at how the Fed has defined the terms “maximum employment” and “price stability” over the years.

Stable Prices

Fed Chairman Alan Greenspan once defined price stability as “that state in which expected changes in the general price level do not effectively alter business and household decisions.” In other words, price stability is when inflation is low enough that people don’t think about changing prices in their daily economic lives. Both in academic circles and among policymakers, the case for putting a formal, numerical inflation target drew growing support in the 1990s. Ben Bernanke, then an academic, and others argued that setting an explicit numerical inflation target makes monetary policy more transparent, coherent, and effective, improves the accountability of the central bank, and encourages greater attention to long-run considerations in day-to-day policy debates. Central banks around the world began to heed this advice. A numerical inflation target was implemented by the Bank of New Zealand in 1990, by the Bank of Canada in 1991, and by the Bank of England in 1992. In 1996, Alan Greenspan unofficially – and privately – set the Fed’s inflation target at 2 percent. The policy-making Federal Open Market Committee adopted a formal 2 percent inflation target in January 2012 during Ben Bernanke’s tenure as Fed chair, saying:

“The Committee judges that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. Communicating this inflation goal clearly to the public helps keep longer-term inflation expectations firmly anchored, thereby fostering price stability and moderate long-term interest rates and enhancing the Committee’s ability to promote maximum employment in the face of significant economic disturbances.”

In 2016, the Fed amended its statement of long-term goals to make clear that its 2 percent inflation target is symmetric; in other words, 2 percent is not meant to be a ceiling. “The Committee would be concerned if inflation were running persistently above or below this objective,” it said.

Maximum Employment

While the Fed and many economists argue that the central bank can determine the inflation rate, most believe that the Fed cannot determine the unemployment rate in the long run (although this has been challenged by some economists recently). The long run or natural rate of unemployment is the lowest level to which unemployment can fall without generating too much inflation. It is determined by factors outside of the Fed’s control, such as government incentives to work, the degree of mismatch between the skills of workers and the demands of employers, and demographics. For this reason, the Fed’s goal isn’t to set the ultimate unemployment rate but to estimate what it is and steer the economy as close to it as possible. Here’s how the Fed describes its employment goal:

“The maximum level of employment is largely determined by nonmonetary factors that affect the structure and dynamics of the labor market. These factors may change over time and may not be directly measurable. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the maximum level of employment, recognizing that such assessments are necessarily uncertain and subject to revision.”

The median recent estimates from Fed policy makers’ Summary of Economic Projections puts the long-term rate of unemployment at 4.6 percent. The Congressional Budget Office (CBO) puts it at  4.65 percent. These estimates are imprecise and subject to change as the economy evolves.

Why not shoot for zero inflation?

The Fed and most economists believe that a little inflation is a good thing. Here’s why:

  1. Textbook economics teaches that when an economy turns down and there are many unemployed people, wages should fall. That’s supply and demand. If they don’t fall, employers will tend to hire fewer workers. What matters to employers, the theory goes, isn’t nominal wages, but wages adjusted for inflation. At zero inflation, the only way to reduce inflation-adjusted wages is to pay someone less—to cut wages, for instance, from $20 an hour to $19.60 hour, a 2 percent wage cut. Cutting nominal wages turns out to be very hard in practice. Neither employers nor workers seem comfortable with doing that. With a little inflation, however, it’s easier to reduce inflation-adjusted wage. At 2 percent inflation, for instance, keeping a worker’s wages at $20 works out to a 2 percent wage cut. In a recession, that will keep more workers on the job than otherwise would be the case.
  2. When the Fed wants to encourage borrowing and spending, it cuts interest rates. The interest rates that matter are those adjusted for inflation (or real interest rates): in a recession, the Fed often cuts inflation-adjusted interest rates below zero. It’s hard—though not impossible—to cut nominal interest rates below zero. With a little inflation, it’s easier for the Fed to get real interest rates below zero when the economy needs support. With 2 percent inflation, a 1 percent nominal interest rate is actually a real interest rate of negative 1 percent — with the important proviso that people continue to expect inflation of 2 percent.
  3. The Fed wants to avoid deflation, a generalized decline in prices and wages. As research has shown, particularly surrounding the Great Depression and the “lost decade” in Japan in the 1990s, deflation (or price declines) can be bad for an economy. Having a little inflation gives the Fed a cushion, reducing the risk that an unanticipated, unwelcome development would lead to deflation.
  4. Many economists believe that the official price measures overstate inflation because they fail to fully account for the improving quality of the goods and services we buy. Setting the inflation target at 2 percent on the official inflation measures accounts for those measurement issues.

Why 2 percent?

Basically, it’s a middle-of-the-road number: one that sets the inflation target above zero but is still within the rough definition of “price stability.” As our colleague Ben Bernanke has said, there is nothing “magical” about 2 percent, but it has become the global standard among industrialized-country central banks.

For some central banks with high inflation rates, adopting a 2 percent rate was an aggressive aspiration. Some central banks target a range rather than a specific number. The Reserve Bank of Australia aims for “an inflation rate of 2 percent to 3 percent, on average over time.” New Zealand’s central bank target range is “between 1 percent and 3 percent on average over the medium term with a focus on keeping future average inflation near the 2 percent target midpoint.” The Bank of England targets 2 percent inflation, but tries to keep inflation within 1 percentage point of its target on either side. If it doesn’t, then the governor of the Bank of England has to write a letter to the Chancellor of the Exchequer explaining why the inflation target was missed. A list of the central banks’ inflation targets is posted here.

So why the interest in rethinking the 2 percent target?

When the 2 percent inflation target began to be widely adopted in the early 1990s, hardly anyone imagined a world in which the Fed would cut interest rates to zero and keep them there for seven years, as it has. Nor did anyone imagine a world in which the Fed would decide that cutting rates to zero was inadequate, so it would buy over $3.5 trillion in long-term bonds to help resuscitate the economy. These developments alone might justify rethinking the 2 percent target.

Another rationale for examination of the 2 percent target is that central banks now estimate that the neutral or natural rate of interest—the inflation-adjusted interest rate consistent with full employment and price stability—is quite low by historical standards. (When interest rates are below that level, they tend to stimulate the economy. When they are below that, they tend to restrain it.) Over the past several years, consensus estimates of this long-run equilibrium interest rate have fallen substantially for reasons that Ben Bernanke explored in a 2015 blog post. Recent research by Fed economists finds that the natural rate of interest is quite low now and is likely to remain low for some time. In December 2017, the median projection in Fed policymakers’ Summary of Economic Projections put the longer run interest rate at 2.8 percent (or 0.8 percent real, assuming a 2 percent inflation rate, the Fed’s target.) In December, the median response to a survey of 23 broker-dealers clustered around the same estimate of the natural rate — 0.75 percent in real terms.

So what does this mean for the Fed? If the natural rate remains low and inflation remains low, it means that the Fed will likely have to keep interest rates low just to remain neutral, and it will have to do so for a long time. Therefore, when the next crisis hits, the Fed won’t have very much room to cut interest rates before it gets down to zero again, and at zero or even a little below, its rate won’t be as stimulative in real terms relative to the natural rate as it was at the bottom of some previous recessions.

Of course, the Great Recession demonstrated that the Fed still has tools to deploy when short-term rates fall to zero, such as buying long-term bonds in what’s known as “quantitative easing.” Chair Yellen has said that these unconventional monetary tools will be sufficient for the Fed to manage the economy even if rates hit zero in some future recession. Others are skeptical.

All this has led several Fed policymakers—including San Francisco Fed President John Williams, Chicago Fed President Charles Evans, Boston Fed President Eric Rosengren, Yellen herself, and several economists outside the Fed—to express interest in re-evaluating the Fed’s 2 percent inflation target. Here’s what Chair Yellen had to say on the topic at the Fed’s June 2017 press conference:

“At the time that we adopted the 2 percent target—it was back in 2012—we had a very thorough discussion of the factors that should determine what our inflation objective should be. And I believe that was a well-thought-out decision…. Now, we’ve learned a lot in the meantime, and assessments of the level of the neutral likely level, currently and going forward, of the neutral federal funds rate have changed and are quite a bit lower than they stood in 2012 or earlier years. And that means that policy could be constrained by the zero lower bound more frequently than at the time that we adopted our 2 percent objective. It’s that recognition that causes people to think we might be better off with a higher inflation objective, and… is one of our most critical decisions…. It’s one that we will be reconsidering at some future time….. [A]reconsideration of that objective needs to take account not only of benefits of the potential benefits of a higher inflation target, but also the potential costs that could be associated with it. It needs to be a balanced assessment. But I would say that this is one of the most important questions facing monetary policy around the world in the future….”

No change is imminent, and any change would present a formidable communications challenge for Fed officials who have spent years talking to the public and markets about the 2 percent inflation target. But there is a lively debate. Here’s a look at the major alternatives.

The Alternatives

1. A Higher Inflation Target

One option is to keep the current framework, but to increase the inflation target, perhaps to 3 percent or 4 percent. In such an economy, once inflation expectations adjusted to the higher rate, short-term nominal interest rates generally would be higher than they would be with a 2 percent inflation rate. And that would give the Fed more scope to cut inflation-adjusted interest rates below zero, when necessary.

Various economists and policymakers have advocated for a higher inflation target in recent years. In June of 2017, for instance, a group of economists wrote a letter to the FOMC endorsing the idea. Here’s an excerpt from the letter:

“Even if a 2 percent inflation target set an appropriate balance a decade ago, it is increasingly clear that the underlying changes in the economy would mean that, whatever the correct rate was then, it would be higher today. To ensure the future effectiveness of monetary policy in stabilizing the economy after negative shocks–specifically, to avoid the zero lower bound on the funds rate –this fall in the neutral rate may well need to be met with an increase in the long-run inflation target set by the Fed.”

One downside of this policy is that during good times, the Fed and the economy overall would have to deal with the costs of slightly higher inflation, which might not meet the Greenspan definition of being low enough to be ignored in most people’s decision-making.

2. Price-level Targeting

Another alternative is to define price stability as a target for the overall level of prices, rather than the change in prices. This approach would lead the Fed to compensate for periods when inflation is below 2 percent with periods where inflation is above 2 percent (and vice-versa when inflation is above 2 percent). In contrast, the current 2 percent inflation target has no such “look back” provision.

The Swedish Riksbank experimented with price-level targeting in the 1930s, but no major central bank has adopted it. Recent work by Federal Reserve Board economists Michael Kiley and John Roberts suggests that a kind of price-level targeting could decrease the frequency and severity of periods in which the Fed was constrained by the zero-lower bound. This finding has been reinforced through other  economic research over the years.

The chart below shows the Core PCE price index against what the core PCE price index would have been had the Fed successfully implemented a price-level target of 2 percent. The light blue line represents a price-level target growing at 2 percent. The dark blue line is what actually occurred.

John Williams, President of the San Francisco Fed, discussed the idea of price-level targeting in a May 2017 speech: “If price growth is a little lower than target, say, during a downturn, the central bank aims to get the price level back up in the years ahead—and vice-versa. Baked into its very design is a ‘lower for longer’ policy prescription in response to sustained low inflation. This helps support the return of the price level to the desired level and anchor inflation expectations even when interest rates are constrained at the lower bound.” It also implies a period of very low inflation or even deflation if the price level is lifted by a decline in the dollar or a surge in commodity prices driven by global demand.

Ben Bernanke and Charles Evans have both advocated for a variant of this policy in which the Fed targets the price level only after a period in which interest rates have been stuck at the zero bound. During such a period, the Fed would engage in price-level targeting, while during more normal times away from the zero-lower bound, the Fed would engage in more traditional, standard inflation targeting.

3. Nominal GDP Targeting

Still another alternative to the 2 percent inflation target is to target nominal GDP. This approach, originally proposed in 1977 by James Meade, would replace the Fed’s 2 percent inflation target with a target for the level of or the growth in GDP—that is, nominal GDP before adjusting for inflation. This, essentially, would combine the Fed’s price stability and employment mandates into a single measure. At some periods, there’d be more inflation and less output growth; in others, there’d be less inflation and more output growth. Essentially, the Fed would set a target for either the level of nominal GDP or the rate of growth of nominal GDP, and cut interest rates when the economy was below that target.

Proponents of this policy argue that it joins both sides of the dual mandate into one easily digestible metric. Indeed, a 2011 memo to the FOMC by Fed economists cited benefits to some features of nominal GDP targeting, along with potential downsides. One downside is that it could require the Fed to raise interest rates if nominal growth surged because of a spurt in productivity, perhaps driven by technology.

Some academic research has supported nominal GDP targeting. Christina Romer of the University of California at Berkeley and a former chair of the White House Council of Economic Advisers argued in 2011 that the Fed should adopt nominal GDP targeting to get the economy out of the rut of the Great Recession: “By pledging to do whatever it takes to return nominal GDP to its pre-crisis trajectory, the Fed could improve confidence and expectations of future growth. Such expectations could increase spending and growth today: Consumers who are more certain that they’ll have a job next year would be less hesitant to spend, and companies that believe sales will be rising would be more likely to invest.”

The Fed isn’t likely to walk away from its 2 percent inflation target any time soon. Doing so would be a big step. But both inside and outside the Fed, the re-examination of the framework is beginning and conversations about the merits of sticking to the status quo versus adopting an alternative are underway. Indeed, minutes of the December 2017 FOMC meeting record that: “Due to the persistent shortfall of inflation from the Committee’s 2 percent objective or the risk that monetary policy could again become constrained by the zero lower bound, a few participants suggested that further study of potential alternative frameworks for the conduct of monetary policy, such as price-level targeting or nominal GDP targeting could be useful.”

For more on this, see the Hutchins Center’s Jan 8, 2018, conference.