Two years into a new framework that was supposed to overhaul how the Federal Reserve conducts monetary policy, the central bank is struggling to tame the one thing it didn’t envisage in its revamp: inflation running way above its target.
Unveiled at the Fed’s Jackson Hole forum in August of 2020, after an 18-month review, the new approach was aimed at a specific peril: How to beat the weak inflation that had long dogged central bankers.
As policy makers return to their retreat in Wyoming’s Grand Teton mountains faced with the hottest inflation in almost 40 years, that problem is a distant memory, posing questions for the framework’s future.
But at the time — when the unemployment rate was 10.2% and annual inflation just 1% in July of that year — it was very real.
Tepid inflation and low neutral rates, which refers to rates that neither spur nor slow the economy, left officials little room to stimulate growth when the economy takes a hit.
‘Broad and Inclusive’
Policy makers emerged from their study, which included a nationwide public listening tour, and adopted an approach that welcomed above-target inflation for some time and strove for maximum employment that is both “broad and inclusive.”
Against the backdrop of the pandemic and a summer of racial reckoning across the US, it was a sharp departure from the Fed’s previous approach of pre-emptively hiking rates in anticipation of higher inflation.
Fast forward — amid criticism they badly missed the inflation threat — and officials now face doubts about the framework, which the Fed has committed to review every five years, including whether it’s time to return to a more traditional approach.
“In the long run, economists and others will probably look at the framework they adopted in August 2020 as having some pretty severe shortcomings,” said Andrew Levin, a former Fed adviser and a professor at Dartmouth College. “Probably the most important one is that they really were focused on fighting the last war — there’s just no question about it.”
Officials, as they take stock, will find clear lessons of how policy should be implemented and how much flexibility they should preserve to shift course when the world changes.
Too Soon to Know
Back in August 2020, they feared a prolonged period of economic weakness as the country battled Covid-19. The low inflation challenge of past decades seemed likely to persist.
But by early the following year, prices had taken a nasty turn and by the fall it became clear the increases were more broad-based and persistent. Officials then faced a reality that seemed far-fetched when the framework was conceived: Inflation running significantly above the Fed’s 2% target.
“The framework itself quickly became irrelevant,” said Ellen Meade, a research professor at Duke University who was a special adviser to former Vice Chair Richard Clarida, the Fed official tasked with overseeing the framework review.
Speaking in June at the European Central Bank’s annual forum in Sintra, Portugal, Chair Jerome Powell explained that globalization, aging demographics, technological developments and other factors were no longer doing as much to keep prices under control.
“What we don’t know is whether we’ll be going back to something that looks more like or a little bit like what we had before — we suspect it’ll be kind of a blend.” Powell said. “We’re learning to deal with it.”
That verdict is still out.
“Maybe it will come back and be relevant again, but maybe it won’t,” said Meade. “Maybe after the dust settles, it will be what looks to be a world with a somewhat higher neutral rate.”
Until they have clarity on the inflationary landscape, policy makers say the issues that slowed their response were not so much related to the framework, but the forward guidance they used to implement it.
In September 2020, Fed officials vowed to keep rates near zero until the labor market reached maximum employment and inflation hit 2% and was on track to moderately exceed 2% for some time.
In December, they followed with guidance saying they would continue purchasing $120 billion a month in bonds until “substantial further progress” was made on the Fed’s employment and price stability goals. Officials signaled they would slow and then stop the asset purchases before lifting rates.
The road map was based on the lessons from the Fed’s previous experience with unwinding emergency support. But policy makers say that in hindsight, it may have been too strict, tying their hands when inflation soared. They needed an escape clause.
“They used guidance that was very forceful in 2020 because at that time they were really worried that there would be years and years of a weak economy and inflation that would be, if anything, low,” said William English, professor at Yale School of Management and a former senior Fed economist. “And that hasn’t turned out to be the problem.”
Labor Market Murky
Another complication was the labor market. Seemingly weak employment growth in August and September 2021 made officials cautious about removing support, but revisions later revealed that job gains were stronger than initially thought.
“If we knew then what we know now, I believe the committee would have accelerated tapering and raised rates sooner,” Fed Governor Christopher Waller said in May. “But no one knew, and that’s the nature of making monetary policy in real time.
Fed officials have largely defended the framework, even while questioning if they could have applied it differently or should make future adjustments. Some are withholding judgment for now.
“I’d have a hard time reassessing the framework right now because I feel like we’re right in the middle of the movie,” said Richmond Fed President Thomas Barkin. “And I don’t really know whether it’s a horror show or a thriller, or a comedy.”