Fed’s testing of new ideas for policy framework already underway

June 5, 2019

By Ann Saphir and Howard Schneider

CHICAGO (Reuters) – Ahead of a landmark monetary policy conference in Chicago this week that has drawn a cast of “A-list” economists, Federal Reserve officials promised an animated and blank-canvas debate over if and how the U.S. central bank should remake its strategy for generating stable prices and full employment.

But that new framework already may be taking shape as Fed policymakers put their latest thinking into practice with a heightened emphasis on boosting labor markets, active encouragement of higher inflation to offset longstanding low inflation, and treating the Fed’s massive balance sheet as a normal part of its toolkit.

Those ideas were the subject of academic studies and sometimes pointed debate during the two-day conference at the Chicago Fed, but “if you look at what they are doing … they are already there,” Nomura Securities economist Lewis Alexander said on the sidelines of the event.

The shift, part of the Fed’s broad acceptance that the economy has changed in fundamental ways that make high inflation far less of a threat, is apparent in its decision to leave interest rates lower than usual as well as in policymakers’ blunt statements that crisis-era bond-buying and other measures will be used again.

It also is a recognition that the Fed’s existing framework, established under former Fed chief Ben Bernanke, provides enough flexibility to do many of the things being discussed as helpful without requiring any broad or hard-to-explain changes.

Since the central bank adopted its current framework under Bernanke in 2012, inflation has run persistently below a 2 percent target, defying policymakers’ expectations as economic growth gained momentum and the unemployment rate fell to near a 50-year low of 3.6%.

Fed officials blame an aging population, globalization, and to some degree their own inflation-taming success in past decades for keeping businesses and markets from expecting a surge in prices at this time.

But low inflation and a decline in the level of interest rates now needed to keep an older, more globalized economy healthy, have taken a toll on the Fed’s ability to fight future downturns.

Top economists presented reams of new research at the conference in Chicago that laid out ways to regain that lost leverage, including a concept called average inflation-targeting, by which the Fed would aim to deliver a set rate of inflation over a set period.

The approach would require central bankers to encourage above-target price rises if low inflation persisted, as has happened in the past several years.

Policymakers also listened to the case for leaning even harder into the Fed’s full-employment mandate. University of Maryland professor Katharine Abraham, who once led the U.S. Bureau of Labor Statistics, laid out her new research on job seekers and changers that suggested labor markets may not be as tight as the unemployment rate suggests.

And policymakers heard new academic arguments for more aggressive use of bond-buying in any coming recession.

Those ideas have already crept into Fed policymaking.

The U.S. central bank’s policy-setting committee has held interest rates steady this year, and Fed Chairman Jerome Powell this week signaled global trade tensions could even open the door to a rate cut despite the low unemployment.

“It is perhaps not too optimistic to suggest that there’s a flip among some monetary policymakers,” Jared Bernstein, senior fellow at the Washington-based Center on Budget and Policy Priorities, told conference attendees.

“High-pressure labor markets once viewed as guilty until proven innocent are now viewed as innocent until proven guilty.”

Indeed, unlike Bernanke, who spent a year getting Fed leaders to agree to the 2% inflation target, nothing in the language so far from Powell or Vice Chairman Richard Clarida, who is leading the review, suggests they are seeking a similar sea change.

(Graphic: The Fed’s balance sheet was a quarter of GDP link: https://tmsnrt.rs/2HvdrGt).


The Fed’s enhanced focus on employment and absence of concern about inflation marks a departure from its traditional reluctance to allow unemployment to fall too far before tapping the brakes with interest rate hikes.

But at least some at the Fed see an entrenched bias toward fighting inflation at the expense of jobs as undermining the public’s confidence in the central bank’s commitment to reaching a 2% inflation target.

“The alternative frameworks are all an attempt to enhance credibility,” Chicago Fed President Charles Evans said on Wednesday. “Whether it is a new framework or just continuing with the existing framework, credibility is the big banana.”

Earlier in the conference, Fed Governor Lael Brainard asked a panel of labor and education leaders how they would advise the Fed to balance its mandates of price stability and full employment.

Juan Salgado, chancellor of the City Colleges of Chicago, noted that while Chicago has an overall unemployment rate of 3.8%, it still has pockets of double-digit unemployment.

“So when I hear we’re at full employment, that’s not my reality, that’s not my community’s reality,” Salgado said. “There’s a lot of people in America that could be helped by having a good job.”

Whether the current review will result in anything more than small tweaks to the Fed’s official long-term strategy remains to be seen. The Fed’s Clarida says the central bank will publish its assessment in the first half of next year.

But with 17 policymakers around the table, building consensus is difficult, particularly on the kind of thorny details that would be needed to enshrine a formal average-inflation-targeting regime, for instance.

And leaving the framework largely intact allows the Fed to preserve its flexibility even as it continues to incorporate new approaches into practice.

“I would be surprised if they went a whole lot further,” said Bill English, a former Fed economist who is now a Yale University professor. “At some level they are doing a bunch of different rethinks right now.”

(Reporting by Ann Saphir and Howard Schneider; Editing by Dan Burns and Paul Simao)

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