9 September 2020
Author: Gavyn Davies, Executive Chairman
The new framework for US monetary policy announced at the Jackson Hole symposium in August is a watershed event, for both the practice of macroeconomic policy, and the theory that lies behind it.
With markets beginning to doubt whether the Federal Reserve can raise inflation to its 2 per cent target, the Federal Open Market Committee has become extremely concerned that it could lose control of inflation expectations, a fate that has already befallen the Bank of Japan and the European Central Bank. The new framework is best interpreted as a last-ditch attempt to avoid this outcome.
It shifts to an average inflation target — which will limit the danger of persistent undershooting of the 2 per cent objective, places maximum employment first among the Fed’s objectives, and abandons any mention of a “balanced” approach to policy.
In the sweep of economic history, this is a very important change. In the Federal Reserve Reform Act of 1977, following a period of “stagflation”, the US Congress gave the Fed three main objectives: maximum employment, stable prices and moderate long-term interest rates, in that order.
In the early 1980s, Paul Volcker crucially interpreted that mandate to place the greatest emphasis on stable prices. He broke the back of double-digit inflation but at the expense of increasing unemployment to above 10 per cent, the highest since the Depression.
By winning the political and intellectual battle for low inflation, Volcker established that the Fed had wide discretion to interpret its 1977 mandate. In 2012, Ben Bernanke’s statement of policy strategy translated the “stable prices” objective formally into a 2 per cent inflation target, which remained paramount in the 2010s.
The objective of maximum employment was now given a minor role in a “balanced” approach to monetary policy, in which the FOMC would seek to mitigate deviations of inflation from its target, and of employment from its undefined maximum level.
Adam Posen of the Peterson Institute is not alone in arguing that this approach has placed far too much emphasis on the need for pre-emptive tightening to control inflation. For example, the increases in interest rates in 2015-18 occurred when there was no major sign of above-target inflation. Even before the pandemic caused a surge in unemployment, this monetary tightening looked misjudged.
Although President Donald Trump’s criticisms of these interest rate decisions has been somewhat vindicated, the FOMC has not been influenced by political pressure in designing the new framework. As Fed chairman Jay Powell and vice-chair Richard Clarida have emphasised, the changes have been motivated by a long period in which inflation has remained below target.
This has occurred when equilibrium real interest rates have fallen to almost zero, leaving very little scope to ease conventional monetary policy in response to a future recession.
The shift to an average inflation target is a useful innovation. But more important is the promotion of the employment objective. Under the 2012 strategy, maximum employment was intended to refer to the natural rate of unemployment that would be consistent with stable inflation in the long run.
Now, maximum employment will be defined more literally, as the greatest utilisation of the labour force that can be attained with the economy working at full capacity. The FOMC’s main aim will be to attain this outcome at all times, unless the average inflation target is severely threatened.
This is similar to the old Keynesian framework of the 1960s, which required monetary and fiscal policy to seek to achieve “full” employment at a time when a strong economy did not appear to be inconsistent with stable prices.
William Martin, Fed chairman in the 1950s and ’60s, believed — like Mr Powell — in a generally low inflation rate, and on occasions raised interest rates to stabilise prices. But he was overtaken by the intellectual zeitgeist. At the end of his term, with inflation pressures clearly rising towards the highs seen in the next decade, he admitted defeat.
Given the persistent contractionary demand shocks triggered by the pandemic, and the deflationary episodes recently experienced in Japan and the EU, the Fed is justified in deciding to risk higher inflation for the immediate future.
But it is worth remembering that this regime eventually triggered the great inflation of five decades ago.