Some Thoughts On New Policy Strategies

Note: This is a longer think-piece that I hope to continue developing in the months ahead. Comments welcome.

The Federal Reserve quickly switched gears between December 2018 and March 2019 as policy became “patient” and the two rate hikes projected for 2019 fell to zero. The backdrop for the shift was stumbling markets, softer growth data, and falling inflation. Fed officials find the turnaround of inflation particularly worrisome. Since adopting an inflation target in 2012, the Fed, in the words of Chairman Jerome Powell, has not “convincingly achieved our 2 percent mandate in a symmetrical way.”

The failure of the Fed to meet its self-defined inflation objective yields a number of both short- and long-term negative outcomes. At a most basic level, the continuing suboptimal inflation outcomes suggest policy has been too tight throughout the expansion that followed the Great Recession. Unemployment could have been reduced more quickly and could possibly still be held sustainably lower than current Federal Reserve forecasts anticipate. Another concern is that persistently low inflation is eroding inflation expectations which, though little understood (see Tarullo (2017)), anchor the Fed’s inflation forecast. The Fed would need to provide even easier policy should they want to firm up those expectations.

Over the longer-run, policy makers increasingly focus on how they should respond to the next recession. In addition to lower interest rates, quantitative easing, and forward guidance, Fed speakers also increasingly anticipate tweaking the policy framework to make up past inflation shortfalls. A version of such a policy is the temporary price-level targeting scheme suggested by former Federal Reserve Chairman Ben Bernanke.

Taken together, the above suggests a high likelihood that policy will at least err on the dovish side. In reality, I think the Fed should not just err on the dovish side, but should instead pursue an explicitly dovish strategy. Arguably it would be foolish if not downright irresponsible to enter the next recession without at least convincingly anchoring inflation expectations at 2%; an effort to do so might entail not just accepting above 2% inflation ahead of the next recession, but actually targeting a higher level to ensure that average inflation prior to the next recession is 2%.

As I think about these topics ahead of the Fed’s much-anticipated Chicago conference on strategy and communications, I become concerned that the Fed won’t follow through with their current dovish inclinations. Can they credibly pursue a dovish strategy approach? Optimally, they need to establish such credibility ahead of the next recession, but I wonder if they will get cold feet when push comes to shove. In other words, could the Fed’s rhetoric lead us into a dove trap?

Continued here as a PDF…