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The Federal Reserve is currently conducting one of its now-regular reviews of its monetary policy strategy. The first one ended up being very controversial, so the outcome of this one could prove interesting.
The US central bank announced last autumn that this examination would focus on two specific areas: the board’s “Statement on Longer-Run Goals and Monetary Policy Strategy” — which sketches out the Fed’s broad approach — and its communication tools.
The result of the review is supposed to be revealed “by late summer” but we got some clues in the composition of a conference the Fed hosted last month, with Jay Powell dropping several hints in his opening remarks.
Goldman Sachs chief economist Jan Hatzius and his team have now published their own thoughts on what might happen. They expect that when it comes to the long-run statement the main change is probably going to be a watering down of the “flexible average inflation targeting” policy unveiled in late 2020:
— The last framework review in 2020 was heavily influenced by a long period of low inflation and concern that a very low neutral rate would make the zero lower bound (ZLB) a more frequent problem in the future. Two of the key ideas that came out of it were that monetary policy should respond to “shortfalls” from maximum employment but not to labor market tightness unaccompanied by signs of inflationary pressure, and “flexible average inflation targeting” (FAIT), under which the FOMC would allow inflation to modestly overshoot 2% after prolonged periods of low inflation in order to average 2% over time and keep inflation expectations anchored.
— Some critics have argued that these ideas contributed to high inflation during the pandemic by delaying the Fed’s response. Chair Powell and senior Fed economists have disagreed with this judgment, but the FOMC is likely to make adjustments to its consensus statement nonetheless. It will likely return to saying that it will respond to “deviations” in both directions from maximum employment in normal times or at least water down the shortfalls language. It will also likely return to flexible inflation targeting (rather than flexible average inflation targeting) as its main strategy, though it is likely to retain the option to use a make-up strategy in some cases when the economy is at the ZLB. The FOMC could also pledge to respond forcefully to deviations of inflation in both directions, in line with the ECB’s recent strategy update. Neither change is likely to have an immediate impact on monetary policy.
Here Alphaville would like to interject that although the timing of FAIT proved to be abysmally unfortunate, the rationale behind permitting inflation to run a little hot if it has for an extended period run below target was and remains sound — even if that opinion is a bit . . .
. . . these days.
It just happened to be implemented in the middle of an extraordinary global economic shock (Covid-19) that had an unpredictable, multi-faceted effect on inflation. That complex inflation shock was then compounded by Russia invading Ukraine in 2022 and resulting sanctions on Moscow, which helped drive food and energy prices higher. And as Isabella Weber et al have show, energy shocks are “systemically significant” drivers of overall inflation.
As Powell himself remarked last month:
The idea of an intentional, moderate overshoot proved irrelevant to our policy discussions and has remained so through today. There was nothing intentional or moderate about the inflation that arrived a few months after we announced our changes to the consensus statement.
Anyhooo, Hatzius reckons that tweaks to the Fed’s communications strategy could prove a bit more meaningful than the informal burying of FAIT in the central bank’s monetary policy strategy statement.
He highlights two specific proposals that could matter to markets if they are implemented later this year:
— The first proposal is to provide alternative economic scenarios to highlight risks to the outlook. Some other central banks do this, but most do not show corresponding monetary policy paths that would help investors better understand the central bank’s current reaction function. The Fed staff already provides detailed alternative scenario forecasts in the Tealbooks, but they are currently only released to the public with a five-year delay. We find that these scenarios have provided context for how the reaction function — at least, the staff’s implied reaction function — has changed in different economic circumstances in the past. This context could be informative to investors if provided in real time, especially if FOMC participants began to provide alternative interest rate projections that corresponded to the staff’s alternative economic scenarios. That being said, the FOMC or staff might be reluctant to publish scenarios that are either politically sensitive or that draw attention to very negative economic outcomes.
— The second proposal is to link FOMC participants’ projections for the economy and interest rates, while keeping them anonymous. This would allow investors to see how each participant thinks the funds rate should be set under their economic forecast, rather than trying to infer a reaction function from committee-wide median economic and interest rate projections that often come from different individuals. We find that this information would likely be useful to investors — knowing the reaction function of the median participant inferred from their linked projections would have helped to predict monetary policy surprises in the past.
Goldman has made the full report available for FT Alphaville readers that might want more than just our quick synopsis, and you can find it here.
