Time To Rethink The Fed’s Framework

Stanley Fischer, vice chairman of the U.S. Federal Reserve, left, Janet Yellen, chair of the U.S. Federal Reserve, center, an
Stanley Fischer, vice chairman of the U.S. Federal Reserve, left, Janet Yellen, chair of the U.S. Federal Reserve, center, and William Dudley, president and chief executive officer of the Federal Reserve Bank of New York, walk outside during the Jackson Hole economic symposium in Moran, Wyoming, U.S., on Friday, Aug. 26, 2016.

Every August, central bankers and economists gather at the Economic Policy Symposium in Jackson Hole, Wyoming, hosted by the Federal Reserve Bank of Kansas City. The symposium topic changes each year, reflecting the most pressing policy issue of the day. Following the bust of the 2001 dot-com bubble, for example, the topic was “Economic Policy for the Information Economy.”

The topic this year was “Designing Resilient Monetary Policy Frameworks for the Future.” The two key words here are framework and future. In an economy that’s increasingly unequal in terms of wealth, wages, and power, the Fed’s framework —which encompasses its goals, tools, and strategies—is of critical importance. As we argue in a new paper, the Fed is past due for a new framework, one capable of dealing with today’s most pressing economic challenges.

The Fed’s current framework involves pursuing a dual mandate for price stability and maximum employment. Central banks in many other countries follow an “inflation targeting” framework that prioritizes low and stable inflation above all else. Similar to these inflation targeters, the Fed has announced an explicit goal of maintaining 2% inflation. The Fed does not explicitly define a number corresponding with maximum employment, but it is clear that both the United States and many European economies have fallen short of this goal in recent years, despite the job market’s considerable progress.

The Fed’s monetary policy is not entirely to blame for the problems associated with labor market slack– weak demand, chronically low or negative inflation, slow growth, stagnating wages, and rising inequality – but it could be part of the solution. That will require more than just fine-tuning, however; it will require a new framework for monetary policy. We aspire for a future characterized by full employment: consistently strong labor market conditions that enable workers across the income distribution to bargain for higher wages.

We recommend several potential frameworks to achieve this full employment future. The least drastic change would be a higher inflation target. Low growth and low inflation have resulted in very low interest rates. When interest rates are near zero, central banks have little room to boost the economy by cutting rates. A goal of 3 or 4 percent inflation, instead of 2 percent, would lead to higher nominal interest rates, giving central banks more room to maneuver.

A bigger but perhaps more effective change would be to switch from inflation targeting to price-level targeting. Under inflation targeting, when the central bank undershoots its inflation target, it is not required to compensate by temporarily overshooting the target. Instead, the price level is permanently lower. Under price-level targeting, in contrast, a central bank would set a target path for the overall price level. If prices were to fall below the path because of low inflation, the central bank would compensate with a temporary boost of higher inflation, restoring prices to the target path. This means that the bank reacts more aggressively to negative demand shocks, keeping employment more stable. In the U.S., inflation has been below target for most of the past four years, but the Fed is not planning to make up for this by keeping inflation above target for a few years.

If the Fed targeted the price level, we would expect more expansionary monetary policy over the next few years. The Fed would wait to raise interest rates until inflation was above 2 percent for at least a few months. This would give the labor market a longer chance to recover.

A nominal income or wage target would entail even larger changes in the framework. Nominal income is a measure of aggregate economic activity. The central bank could set a target path for nominal income, and aim to keep it growing at, say, 5 percent per year. Steady nominal income growth is a good indicator of stable employment conditions. This type of framework could promote more stable output and employment, while keeping inflation low on average, and may be easier for the public to understand than inflation targeting, boosting people’s confidence and ability to plan for the future. Under nominal income targeting, the Fed would have acted earlier and more aggressively in the financial crisis. This likely would have resulted in a less severe downturn.

The Fed discussed the possibility of nominal income targeting at the November 2011 Federal Open Market Committee (FOMC) meeting, acknowledging that it could facilitate stronger economic recovery while maintaining price stability but expressing concern that switching to a new framework could heighten uncertainty about future monetary policy. Other central banks have been similarly reluctant to alter their monetary policy framework, and none has yet implemented price-level or nominal income targeting.

This reluctance is understandable, as such a change would be challenging to communicate and implement in the short run. In her Jackson Hole speech, Fed Chair Janet Yellen stressed that “the FOMC is not actively considering” a new framework like price-level or nominal income targeting, though she added that “they are important subjects for research.” But we think the time for active consideration has come. The last part of the Jackson Hole topic—“for the Future”—should challenge all symposium participants to think beyond the short run and to think big. We believe that this means prioritizing full employment and seriously considering alternative strategies for achieving it.