Fed’s Review Misses Fiscal Forest For Monetary Trees

To rescue monetary policy from waning potency, the wider macroeconomic policy framework needs to be overhauled, writes Paul Sheard

The  Federal Reserve building stands in Washington, D.C. (Photographer: Andrew Harrer/Bloomberg)
The Federal Reserve building stands in Washington, D.C. (Photographer: Andrew Harrer/Bloomberg)

The Federal Reserve’s much-anticipated review of its monetary policy framework was a blinkered exercise. The Fed avoided the obvious implications of the very motivation for its review: when a central bank is forced to operate at or close to the “effective lower bound” of its policy rate, the case for fiscal policy to be brought into the picture is compelling.

The Fed’s review was motivated by the recognition that, for the foreseeable future, its monetary policy stands to be constrained by the fact that realistically it cannot lower the policy rate much below zero, if at all. The Fed believes that, due to poorly understood structural changes in the economy, the ‘neutral’ real rate of interest, and therefore the neutral federal funds rate, are much lower than in the past, around half a percent and two and a half percent, respectively.

To the monetary policy cognoscenti, this has a potentially dire implication: the public’s inflation expectations, which for successful monetary policy need to be anchored around 2%, may gradually drift below that level. This is because longer-than-usual periods of the Fed having to operate at or near the effective lower bound will tend to be associated with inflation running consistently below the Fed’s 2% target. This has been the experience of the past decade and Japan’s experience for the past quarter of a century.

If, after such periods, the Fed aims just to get inflation back to 2%, letting disinflationary bygones be bygones, average inflation over time will be less than 2%, which may cause the public’s inflation expectations to fall, stymieing the Fed’s ability to achieve its target.

The implications are clear: to rescue monetary policy from its waning potency and to raise the neutral real interest rate, the wider macroeconomic policy framework needs to be overhauled to facilitate better coordination and joint mobilisation of monetary and fiscal policy.

Rather than pursue this logic, the Fed tweaked its monetary policy framework in two ways.

One tweak is good. The Fed has abandoned the idea that sometimes it might have to preemptively tighten monetary policy to head off labor market overheating, the feedstock of higher inflation. Henceforth, the Fed will focus on shortfalls from full employment and wait to see evidence of labor market-driven inflation before it tightens policy on those grounds.

The second tweak, “average inflation targeting”, while having some impressive logic behind it, seems too clever by half. In future, the Fed intends to target average inflation of 2% over time, meaning that, following periods when inflation has been running below target, it will aim for inflation to run above 2% for some time. The Federal Open Market Committee incorporated this approach in its somewhat underwhelming statement on Wednesday.

While appearing to be an elegant theoretical solution to the Fed’s predicament, this new approach begs many questions. How will the inflation expectations of the public be influenced by needing to understand that, in some periods, the Fed will be targeting more than 2% inflation so as to anchor its inflation expectations at 2%?

An approach that sees the solution to consistently undershooting the inflation target to be, at times, aiming to overshoot it smacks of doubling down on a policy of dubious efficacy.

Although the Fed does not explicitly mention it, if inflation runs persistently above 2% for a period, average inflation targeting will require it to aim to for below-2% inflation for some time, implying a tighter than usual policy. How politically palatable would this be and how would it gel with the Fed’s new-found enthusiasm for maximum employment?

In conducting its review and in announcing its results, the Fed made a big play of the fact that it took extensive input from the public in fifteen “Fed Listens” events around the country, as well as holding a high-level academic conference and receiving thirteen briefings by staff at five consecutive FOMC meetings. As praiseworthy as this openness and thoroughness is, conspicuously absent from the review was any evidence of formal input from the Administration or the Congress being sought or received.

The reason of course is that the Fed zealously guards its ‘independence’, not of the government but within the government as the Fed itself puts it, and successive administrations and congresses have respected this norm.

Central bank independence is a means to an end, not an end in itself.

It arose as a solution to the twentieth-century problem of governments abusing their access to the printing press and causing inflation to be too high as a result. The more proximate threat now is of inflation consistently being too low.

The solution to that problem is staring us in the face. Now that the Fed has completed its review, a more comprehensive one of how monetary and fiscal policy can and should work together, and how that process should be governed and communicated to the public, is badly needed.

Paul Sheard is a research fellow at Harvard Kennedy School and former chief economist at Lehman Brothers, Nomura Securities, and S&P Global.

The views expressed here are those of the author and do not necessarily represent the views of BloombergQuint or its editorial team.