Six Ways The Federal Reserve Can Do A Better Job

The US Federal Reserve is undertaking a major rethink of how it manages the world’s largest economy. Done right, the so-called monetary policy framework review could render the central bank much better able to handle the kinds of economic shocks and policy uncertainties that the current US administration has proven adept at delivering.Chair Jerome Powell shouldn’t let President Donald Trump get in the way of this crucial work.Amid Trump’s on-again-off-again threats to attempt firing Powell, the Fed chair might be tempted to take a “nothing to see here” approach, opting for minimal changes. This would be a mistake. The current monetary policy framework has serious flaws. Correcting them would demonstrate leadership and bolster the case for central bank independence.A new Group of Thirty report, of which I was the primary author, advocates six key reforms:1. Return to a symmetric 2% inflation target.At the 2020 framework review, after a long period of too-low inflation, the Fed adopted a “flexible average inflation targeting regime,” in which shortfalls below 2% were to be offset by misses to the upside but not vice versa. The change made communication more difficult, creating uncertainty about how much inflation would be enough to compensate for past shortfalls. It also proved ill-timed: In the next five years, inflation ran persistently above the 2% target. Meanwhile, a rising “neutral” short-term interest rate (the rate that neither stimulates nor damps economic activity) eased concerns that the Fed could again get stuck at the zero lower bound. To reduce confusion and to be prepared for any scenario, the Fed should return to a symmetrical approach, simply aiming for 2% all the time.2. Aim for a level of employment consistent with the 2% inflation target.The Fed’s employment objective from the 2020 review is also one-sided: It aims to minimize shortfalls from maximum sustainable employment — that is, the level that doesn’t put too much upward pressure on wages. This informed the Fed’s commitment to keep short-term rates near zero until employment had reached the sustainable maximum and inflation had both hit 2% and was expected to stay above 2% for some time. As a result, the central bank didn’t start raising rates until early 2022, even as the economy was growing fast, the labor market was too tight and inflation had climbed above 5%.3. What’s the priority, inflation or employment, when the two goals are in conflict?As the Trump administration’s tariff policies push up both inflation and unemployment, the Fed will face a dilemma: Keep rates higher to combat inflation or ease to support hiring. Providing greater clarity will help markets understand what to expect — even if they may not necessarily like the answer.4. Develop a framework for quantitative easing and tightening.The Fed’s asset purchases have helped support both financial markets and the economy. Yet the Fed hasn’t always clearly differentiated between the two: At the onset of the Covid pandemic, purchases to support the Treasury market slowly evolved into monetary accommodation. Also, the central bank must consider both benefits and costs. The quantitative easing of recent years could end up costing $500 billion to $1 trillion in foregone earnings because the interest it earns on its holdings is less than it pays in interest on bank reserves.5. Publish both baseline and alternative staff forecasts at the conclusion of each policy-making meeting.Markets have become too focused on the median projections for growth, inflation, employment and short-term interest rates in the forecasts published after every other policy-making meeting. Better to help people understand how the central bank would likely react in different scenarios. This would help make monetary policy more effective and would be particularly useful at a time when the US administration’s policies are highly uncertain.6. Develop a framework for forward guidance.Forward guidance can be powerful — for example, when the Fed commits to keeping interest rates low for a long period. But when is it relevant – only when interest rates are stuck at zero, or at other times, too? What if a commitment proves problematic — what kind of escape clause would be appropriate? Can there be softer forward guidance? How does it differ from “data dependence?” A framework, made available to the public, would help dispel confusion.I agree with Powell that the Fed shouldn’t consider increasing its 2% inflation target. Such a move could undermine the Fed’s credibility and unanchor inflation expectations. Meanwhile, the main advantage — reducing the risk of getting pinned at the zero lower bound — has waned as the neutral short-term interest rate has risen.Beyond that, though, there’s a lot the Fed can do to improve the functioning of monetary policy. For one, it should target the interest rate it pays on bank reserves instead of the federal funds rate, which tracks an increasingly idiosyncratic market and requires undue effort to manage. Also, it should exclude reserves from banks’ leverage limits, so that quantitative easing (which boosts reserves) doesn’t conflict with those limits. Finally, it should more formally consider how monetary policy can affect financial stability: Its asset purchases, for example, flooded banks with deposits that some invested in long-term Treasury securities and other fixed income assets. This resulted in heavy losses when the Fed raised rates sharply in 2022 and 2023, contributing to the 2023 regional banking crisis.Powell deserves credit for conducting monetary policy framework reviews. Every economic cycle offers lessons that demand change. The Covid pandemic and its aftermath are no exception..Disclaimer: The views expressed here are those of the author and do not necessarily represent the views of NDTV Profit or its editorial team. .Fed Chair Jerome Powell Walks Tightrope Of Being Late But Not ‘Mr. Too Late’

Six Ways The Federal Reserve Can Do A Better Job

Chair Jerome Powell shouldn’t let President Donald Trump get in the way of this crucial work.

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