The Politics of the Fed’s New Framework

 In

This year, the annual cen­tral bank­ing con­fer­ence at Jackson Hole was held online, and for the first time the Federal Reserve had con­duct­ed a review into its mon­e­tary policy strat­e­gy. Chairman Powell’s keynote address announced that the Fed would allow infla­tion to run above the 2 per­cent target and would no longer treat low unem­ploy­ment as suf­fi­cient cause for policy tight­en­ing.

The biggest shift in a decade, this may have long-term polit­i­cal con­se­quences.

The Review

The review was in response to years of below-target infla­tion and a decline in the neu­tral rate of inter­est. In addi­tion to an aca­d­e­m­ic research con­fer­ence and inter­nal work­ing groups, the Fed also hosted a series of unprece­dent­ed public con­sul­ta­tions with groups includ­ing unions and minori­ties.

The head­line announce­ment was the adop­tion of aver­age infla­tion tar­get­ing. Instead of a fixed 2 per­cent target, peri­ods of low infla­tion will now be “made up” by peri­ods of sym­met­ri­cal­ly higher infla­tion. Since infla­tion has been below target for more than a decade, these “make ups” could be sig­nif­i­cant.

In addi­tion, low unem­ploy­ment will no longer be suf­fi­cient to trig­ger a policy reac­tion. Previously, policy would be pre­emp­tive­ly tight­ened as unem­ploy­ment neared esti­mates of its “nat­ur­al rate.” This logic led the Fed to raise rates four times in 2018 when unem­ploy­ment fell below 4 per­cent, only for infla­tion to stay flat. That will no longer happen. Low unem­ploy­ment will only trig­ger policy action if infla­tion actu­al­ly increas­es. This will allow the Fed to run a “high pressure economy,” pur­su­ing growth for longer to bring mar­gin­alised groups back into the labour market.

So what?

The new relaxed atti­tude towards infla­tion has led some to warn of hyperinflation. Most respons­es have been more muted. The Fed’s announce­ment was antic­i­pat­ed for some time, but it is more evo­lu­tion than rev­o­lu­tion. The Reserve Bank of Australia already does a ver­sion of aver­age infla­tion tar­get­ing.

So, what will change? Right now, not a lot. The Fed is sig­nalling that policy will remain accom­moda­tive for a long time to come, and mar­kets have con­tin­ued their bull run. COVID-19 has depressed both infla­tion and employ­ment, so it will be many years before the Fed’s new lenient atti­tude to infla­tion is tested.

An Uncertain Future

Beneath the tech­ni­cal­i­ties of tar­gets and tight­en­ing, two longer-term trends are at work.

There is an age-old argu­ment in cen­tral bank­ing between advo­cates of rules and advo­cates of dis­cre­tion. For the former, mon­e­tary policy should be deter­mined by mechan­i­cal rules. The famous Taylor Rule, in use before the GFC, is an equa­tion that pro­vides the ideal inter­est rate based on the level of income and infla­tion.

Advocates of dis­cre­tion argue that uncer­tain­ty and tech­ni­cal inac­cu­ra­cies make rule-based policy making rigid and inflex­i­ble. If the unpre­dictable post-crisis econ­o­my had already given them the upper hand, then Powell’s announce­ment was the vic­to­ry lap. Under the new approach, the Fed will have dis­cre­tion to decide how far above the target infla­tion can rise, and over how long a period the aver­age will be cal­cu­lat­ed.

Greater agili­ty comes with risks. Monetary policy is polit­i­cal, full of dif­fi­cult deci­sions that create win­ners and losers. The famed Volcker shock con­tributed to the decline of US manufacturing and the Latin American debt crisis. Quantitative easing has prob­a­bly exac­er­bat­ed inequal­i­ty. Mechanical rules are a polit­i­cal guardrail, a defence against accu­sa­tions of bias, and they pro­tect inde­pen­dence.

Part of their attrac­tion was the puta­tive real-world rela­tion­ships they were based on, most famous­ly the Philips Curve. It posit­ed an inverse rela­tion­ship between unem­ploy­ment and infla­tion. Lower unem­ploy­ment leads to wage increas­es which flow through to higher infla­tion; high unem­ploy­ment has the oppo­site effect. The break­down of this rela­tion­ship – record low unem­ploy­ment through 2018 and 2019 barely moved infla­tion – is part of the reason rules-based approach­es have lost their appeal.

But dis­cre­tion-based policy making is risky busi­ness for a polit­i­cal­ly inde­pen­dent insti­tu­tion. “We have your best inter­ests at heart” is cold com­fort to those on the wrong end of an inter­est rate hike. The kinds of cre­ative policy that dis­cre­tion allows, like bank bailouts and neg­a­tive inter­est, gen­er­ate con­tro­ver­sy. Discretion is doubly risky in a polit­i­cal cli­mate where Trump has normalised once inconceivable attacks on the Fed.

This helps explain the second trend, the Fed’s attempts to build a closer rela­tion­ship to the public. Transparency and account­abil­i­ty have become the Fed’s new watch­words. References to “the public” in speech­es are at an all-time high. In his address, Powell repeat­ed­ly spoke about minori­ties and low-income groups. The Fed Listens events put the Fed face to face with groups it usu­al­ly only dealt with through aggre­gate sta­tis­tics. The trend extends beyond the Fed. The Bank of England has start­ed Citizen’s panels to con­nect with the public, and the European Central Bank (ECB) has signaled cautious approval for work­ers and unions demand­ing higher wages.

Greater trans­paren­cy and public engage­ment help offset the imme­di­ate polit­i­cal risks asso­ci­at­ed with dis­cre­tion, but they open mon­e­tary policy to future debates that Central Bankers might find uncom­fort­able. In admit­ting the policy errors of the prior frame­work (like the 2018 rate hikes), the Fed opens the door to future ques­tion­ing. With no rules, the Fed’s judge­ment is up for crit­i­cism, even as greater public engage­ment intro­duces new, some­times angry voices to the con­ver­sa­tion.

This can only be a good thing. Monetary policy has always been con­spic­u­ous for its aloof­ness. The first press offi­cer at the Bank of England was told to “keep the bank out of the press and the press out of the bank.” The nature of the post-crisis econ­o­my is still far from cer­tain, and the twelve years since the crisis have shown that Central Bankers are learn­ing on the fly like the rest of us. In a democ­ra­cy, it is only fair that this be up for debate.

Lewis Jackson writes about eco­nom­ics and pol­i­tics with a spe­cial inter­est in inter­na­tion­al pol­i­tics and cen­tral banks. He has a Masters in Public Policy and Political Economy and worked as a man­age­ment con­sul­tant for sev­er­al years. You can find more of his writ­ing here.

This arti­cle is pub­lished under a Creative Commons License and may be repub­lished with attri­bu­tion.

Australian Institute of International Affairs source|articles

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