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Three experts on the monetary policy challenges the Fed now faces

Did the Federal Reserve wait too long to raise interest rates to restrain inflation?  Is the Fed’s new monetary policy framework working out as the Fed hoped it would? What are the biggest monetary policy challenges that the Fed faces in the next couple of years?

The Hutchins Center put those questions and others to three experts on monetary policy at a March 2, 2022, event: Henry Curr, economics editor of The Economist;  Jon Steinsson, Chancellor’s Professor of Economics at the University of California, Berkeley, and co-director of the National Bureau of Economics Research’s monetary economics program; and  Joseph Gagnon, a senior fellow at the Peterson Institute for International Economic and a former senior Fed staffer.

Here is a summary of their comments. (You can also watch a video of the conversation, moderated by the Hutchins Center’s Louise Sheiner.)

Is the Fed behind the curve?

Yes, said Curr. Incoming data, particularly wage growth, are inconsistent with the Fed’s 2 percent inflation target. “What the Fed said last year was, in effect, we’re not that worried about inflation because inflation expectations are anchored so we, therefore, think inflation will be transitory,” and thus monetary policy can focus on the other half of the Fed’s mandate, maximum employment. “When I was taught economics, I was taught that the reason you have independent central banks is to avoid a situation where short-sighted politicians….push as hard as they can on the employment side of their mandates….It’s not all clear to me how pushing as hard as you can on employment while pointing to inflation expectations being anchored as the justification is all that different from the inflation-bias scenario that the textbooks warn about.”

Steinsson said that Fed policy during 2021 “given what they knew at the time” was sensible. “Being patient throughout most of last year given the developments that were hitting the economy at the time, the supply shocks and the shifts in demand from services to goods are both things that, I think, make sense to allow to at least temporarily raise inflation above the target.” But, he added, the Fed waited too long to pivot to a less accommodative stance. At their November 2021 meeting, Fed policymakers should have changed its forward-guidance language to suggest that it anticipated raising interest rates soon. Policymakers did change their message shortly after that meeting, but, Steinsson said, “by that time they were behind the curve and their remain behind the curve even today….The gap between what [level of interest rates] is appropriate right now and where they are is very large.”

Gagnon said the Fed and other forecasters should have expected the $1.7 trillion CARES Act to boost aggregate demand substantially and push up inflation, but the supply shocks – the reluctance of workers to return to the job, for instance, and the remarkable surge in demand for goods versus services – were not foreseeable. “So we had two big supply shocks and one big demand shock. And the net effect was that the demand shock would tend to push both prices and output up and the supply shock would tend to put prices up but output down.” The net result was that inflation was “way higher than anyone expected, even those of us who warned about inflation.” While he agreed with Steinsson that the Fed should have pivoted in November, Gagnon said a couple of months is not a big deal, and noted that the Fed has now signaled it will raise rates and markets anticipate that.

What should the Fed do now?

Steinsson recommended that the Fed should raise short-term interest rates by half a percentage point at each of the next four meetings of policymakers, which would bring the key federal funds interest rate (which has been at zero since March 2020) to 2 percent by July. “Before you conclude that I’m crazy, you should reflect on the notion that if the core CPI inflation rate is at 6 percent, is it really so crazy to have a federal funds rate of 2 percent by July?” What the Fed should do after that depends on incoming data, he said. “One thing that may be holding the Fed back…is a perception that it’s very costly to reverse course….It’s not a law of nature that when the Fed changes interest rates that’s going to stick for many, many years…. And I think we may be at a moment where the appropriate policy is for the Fed to rapidly raise rates but make it very clear to markets that those rates might be reversed. In particular, if the Fed is raising rates above 2 percent then it may be appropriate, if inflation comes down quickly, to reverse those increases rapidly and…it’s important for the Fed to explicitly signal that that may happen.”

Gagnon said Fed Chair Jerome Powell Fed needs to be nimble, but need not rush. “He does need to show he’s on the ball….If inflation doesn’t come down as fast as they expect, which is actually what I expect, so then I think they will have to do more, and I hope they do.  But it’s also possible that output may not grow as fast, and they should be cautious of that too.”

How well is the Fed’s new Flexible Average Inflation Targeting framework working?

Gagnon described the new framework as “a small step in the right direction” because the Fed needed to avoid a framework that, because interest rates are more likely to hit zero than used to be the case, would produce long periods of below-target inflation and higher-than-necessary unemployment. But the change came at an unfortunate moment when inflation was about to surge well above the 2 percent target.

Steinsson declared himself to be “a big fan of the change” in the framework and that the new framework abandoned the past approach of aiming for 2 percent inflation without taking into account of long periods in which inflation was below target – the let bygones be bygones approach. “I don’t think that what has happened since then is the fault of this framework.”

All three panelists expressed frustration that Fed officials have not been more explicit about how much they think the large-scale purchases of bonds – quantitative easing – reduced long-term interest rates, and what effect they think reducing the size of the Fed’s portfolio will have.

What about the Fed’s 2 percent inflation target?

Gagnon said, “I worry that two years from now inflation will have come down a lot, but it will not be 2 percent… Say it’s leveling out at 3 percent, and maybe long-term inflations have crept up to be consistent with that, slowly….Then the Fed has a choice. Do we get back to 2 and basically slow the economy down or even cause a recession to get back to that 2, or do we do what we should have done years ago and change our target to 3? The biggest argument against changing the target is just the loss of credibility. They have put so much into the credibility of their 2 target everywhere, not just here but around the world, and people say if they raise it to 3 now when things look tough, what’s to keep them from raising it to 4 later when things are tough again, or bringing it back to 2 if things look good?”

“Why should people believe them? One, no target should ever have been thought of as permanent. They have said there are going to revisit this every five years. [And, two] it absolutely cannot be the right policy choice to choose a bad policy target because it’s too hard to explain a better target… They should do what’s best for the economy and figure out how to sell it. Get some Madison Avenue types, whatever. Figure out how to explain to the American people that this is in their interest to get it right.”

Curr countered that he wouldn’t want to see the Fed move to a 3 percent target anytime soon. “It does pose a risk to the Fed’s credibility and central banks’ credibility if they’re faced with a big problem, and then they change course in that manner.”

Steinsson added, “I’ve long been sympathetic to the notion that there’s nothing special about 2 and certainly that theoretically a higher inflation rate makes a lot of sense. So in the classroom I’m very sympathetic to 3 or 4, but, you know, I think we have to be humble about the fact that our models don’t seem to really capture how much people dislike inflation… There’s this old line that inflation should be low enough that people are not thinking about it.  And, I do think that is something that makes a lot of sense. And whether that’s 2 or 3, I’m not quite sure about.”

The equilibrium or neutral level of interest rates—the one expected to prevail when the economy is at full employment and price stability—has been falling for decades. Is that trend likely to return when today’s high inflation abates?

“It is entirely possible that we’re going to find ourselves back in that world where rates are very low and the Fed is persistently undershooting its [inflation] target,” Steinsson said. “There are certainly global forces that are very strong that are pushing in that direction – increased inequality, demographic change, high savings rates in certain parts of the world. But I’m more worried about things in the opposite direction… [S]ome of us are starting to worry a bit about whether it really is the case that the Fed is going to do whatever it takes [to bring inflation down toward 2 percent]. And the more the Powell Fed chooses to go a route that is not very hawkish….the more I think it is possible that some cracks in this formidable armor of reputation will start to appear.”

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