Monetary Policy Renormalization: ... Point 3: Toward a Better Reaction Function I’ve argued that, in November 2009, the FOMC was aiming for a slow recovery in both prices and employment. I’ve argued too that the Committee’s desire for a slow recovery was consistent with its pre-2008 reaction function, which sought to constrain the variability of short-term interest rates. I now turn to the question of how the FOMC could change its “normal” policy reaction function so as to engender a better response to severe adverse shocks.
To be clear, there have been many prior suggestions about how to arrive at a better framework. Some observers have suggested that the FOMC should increase the inflation target, so as to have more policy space to deal with adverse demand shocks. Some observers have suggested that the FOMC should target the price level rather than the inflation rate. Still others have suggested that the FOMC should target the level of nominal income.
I see merit in all of these suggestions, and I welcome explorations of their consequences. But they represent large changes in the FOMC’s long-run goals. I will instead recommend a more minimal change in terms of the FOMC’s strategy—that is, how it seeks to pursue its current long-run goals. My recommendation is that the FOMC should adopt a policy framework that puts considerably more emphasis on returning the economy to its dual mandate objectives over the medium term. Such a framework would immediately imply that the FOMC should use a monetary policy reaction function that is a lot more responsive to the Committee’s best medium-term projections of inflation and output gaps.
What would be the benefits of this change in the FOMC’s strategic framework? I see two clear benefits. First, the FOMC’s choices would systematically return both inflation and output to desired levels more rapidly. There would be less persistence and less volatility in both inflation and output gaps. Second, the credibility of the FOMC’s inflation target would be enhanced. As noted earlier, in November 2009, the staff projected that, if the FOMC used the Taylor Rule after liftoff, inflation would remain at 1.6 percent or below for the next five years. This kind of outcome creates large downside risk to the credibility of the inflation target.
Those are the benefits: less variance in macroeconomic variables and enhanced credibility of the FOMC’s long-run inflation target. What would be the costs? The key cost is that, of course, the fed funds rate would be more variable around its long-run level. I have two comments about this putative cost. First, I don’t know of models in which such a cost is grounded in traditional welfare economics.10 The real interest rate is a key intertemporal price, and it may need to vary a lot to effect a desirable allocation of resources. According to models that are currently available, it would be welfare-reducing to smooth the fluctuations of this important price.
Second, and perhaps relatedly, my reading of the Federal Reserve Act is that Congress has not mandated that the FOMC seek to constrain the variability of its policy instruments. Congress has mandated that the Committee adjust its policy instruments as needed so as to achieve its macroeconomic objectives.11
To summarize my third and final point: The FOMC should strongly consider lowering its implicit penalty on interest rate variability relative to what was being imposed before the crisis. Doing so would lead the Committee to use a monetary policy reaction function that puts more weight on its forecasts of inflation and output gaps. Such a reaction function would automatically engender a more appropriate monetary policy response to severe downturns in inflation and employment such as those experienced during the Great Recession.
The theme of this speech is that the FOMC’s thinking about appropriate monetary policy in extraordinary times like late 2009 is heavily influenced by its policy framework during normal times. It should choose its new “normal” policy framework with this in mind. I have argued that the pre-2008 framework led the Committee to aim for a relatively slow recovery in inflation and employment in the wake of the Great Recession. I’ve recommended that, going forward, the Committee should use a reaction function that would be considerably more responsive to its best available forecasts of inflation and output gaps.
The U.S. House recently passed a measure, the Fed Oversight Reform and Modernization Act, that would enshrine the Taylor Rule as a key benchmark for monetary policy. Federal Reserve Chair Janet Yellen recently wrote in a letter12 to House leaders that the bill “would severely impair the Federal Reserve's ability to carry out its congressional mandate to foster maximum employment and stable prices and would undermine ability to implement policies that are in the best interest of American businesses and consumers.”
My argument today gives a concrete example of Chair Yellen’s criticism. The FOMC did treat the Taylor Rule as a key benchmark for monetary policy during the early part of the recovery from the Great Recession. By doing so, we were systematically led to make choices that were designed to keep both employment and prices needlessly low for years.
Ultimately, if this legislation were to become law, it would force the Federal Reserve into the same kinds of choices in the wake of future adverse shocks.