Notes on the Fed

From outside the Federal Reserve (Fed), it is hard to imagine how so many people could work so hard for so long on the Fed’s review of longer-run strategy so as to insert the word “average” in its annual statement. Why does it matter to Fed officials and what did they just do?

Quite tellingly, Fed Chair Powell sometimes refers to the Federal Open Market Committee’s (FOMC) “Statement on Longer-Run Goals and Monetary Policy” as its Constitutional document. A lawyer does not throw around such a term loosely. The statement, normally ratified at the first meeting annually since 2012, represents the Fed’s interpretation of the goals assigned to it, just as Congress was assigned the power “to coin money” in the Constitution. Guiding monetary policy by this mission statement is the quid pro quo for the power to conduct monetary policy. Thus, the annual statement that was ratified on August 27 matters to them.

While the annual statement is only one page, Fed Chair Jay Powell took 22 pages in his Jackson Hole remarks to explain it (with four pages of references and four pages of charts). The changes and his remarks rest on four pillars.

1. The FOMC strongly endorses a dual mandate of maximum employment and price stability. This, in part, provides the assurance that their attention on inflation is not at the cost of concerns about unemployment.
2. The numerical goal of 2 percent inflation consistent with price stability in the long run requires them “…to achieve inflation that averages 2 percent over time…” They judge this as making it more likely that longer-term inflation expectations will remain well anchored at 2 percent. It also allows the Fed to compensate subsequently for misses from its inflation goal. The statement reads “…following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
   
   
   1. This introduces an element of price-level targeting, implying that prior monetary policy performance is indicative of future behavior. Monetary theorists adore such a rule because it allows policy makers to lower rates aggressively in the midst of a downturn while making it more likely inflation expectations remain anchored.
   2. Average inflation targeting is supposed to be symmetric—when inflation runs below 2 percent, expect a subsequent overshoot, and when inflation runs above 2 percent, expect a subsequent undershoot. In the exercise of situational ethics, the Fed only mentioned the former, not the latter. This is one of the criticisms of the approach. Inflation below goal will be used to justify policy accommodation but the Fed is unlikely to intentionally go below 2 percent to offset inflation above goal. Because of the asymmetric application of letting bygones be bygones, inflation and inflation expectations will likely average above 2 percent to the detriment of central bank credibility.
3. Powell and his committee emphasized that there is no single metric for maximum employment. This recognizes that policy makers were repeatedly surprised during the economic expansion about how low the unemployment rate could get. It also reflects the increased pressure on the Fed to be sensitive to the distribution of income and the labor market conditions of minorities. This continues the transition in the Fed’s conduct and communication of policy begun in earnest by Janet Yellen.
4. Powell warned that the Fed is likely to use more of its tools than just the policy rate, and more often than previously. The logic is that in an environment of significant resource slack, slow trend growth, and elevated uncertainty, the natural real rate of interest is likely low and the policy rate is likely to be constrained more often by its effective lower bound. If so, more will be needed more often.

Overall, the Fed has shifted its approach to the statement of longer-run monetary policy strategy. It was originally designed to be timeless by conveying policy over the longer-run, and was approved annually with few changes. This latest version puts more in play regarding the current situation. The intent is to reassure people that the Fed will not raise interest rates prematurely. The next step would be to use this statement of goals to frame an outcome-based policy rule, or the promise not to raise rates as long as its latest forecast fell short of its longer-run goals. By raising the implied inflation goal, it stretched the date of policy reversal further into the future.