Board of Governors of the Federal Reserve System

August 27, 2020

The Federal Reserve’s Review of Its Monetary Policy Framework: A Roadmap

David Altig, Jeff Fuhrer, Marc P. Giannoni, and Thomas Laubach

In early 2019, the Federal Open Market Committee (FOMC or the Committee) launched a comprehensive review of its monetary policy framework (MPF)—the strategies, tools, and communication practices employed by the Federal Reserve to achieve its congressionally mandated goals of maximum employment and price stability. A key part of this review involved a series of memos written by the staff from around the Federal Reserve System, intended to inform the FOMC's framework discussions. This note serves as an introduction to this series and lays out the work that was presented to FOMC participants between July 2019 and January 2020.¹

The framework review represented by the collection of papers described in this note should not be taken to suggest that the Federal Reserve's MPF has remained largely untouched over the decades. In fact, the framework has changed almost continuously since its inception.² Some changes in framework arose from changes in legislation, some were adopted proactively based on improved understanding of monetary economics, and some were born out of necessity when significant flaws in the existing framework were exposed by economic events. No matter the source, change has been the constant—from the gold standard, to the use of intermediate monetary targets, to use of the interest rate as the primary instrument, and to the explicit numerical inflation objective adopted in 2012.³ The era since the Global Financial Crisis (GFC) saw an even more rapid evolution of the framework, including the use of forward guidance (FG), the adoption of balance sheet policy (BSP), and the introduction of the Summary of Economic Projections (SEP) and regular press conferences. But despite the many changes in the framework over the years, the FOMC has not adopted a regular, systematic process for reviewing its MPF until the current review started in early 2019.⁴

Importantly, virtually none of the System's informal efforts to evaluate its framework have sought to include input from a broad array of constituents. Traditionally, the Fed has regular and ongoing contacts with financial market participants, academic experts, and business contacts who offer their advice on how the FOMC's policies might be improved. But the Fed has not to date systematically solicited input about the MPF performance from other sectors—such as institutions that represent low-income and minority residents, labor, or the retired. As part of this framework review, all of the Reserve Banks and the Board organized events to bring together representatives from all of these communities, in addition to soliciting input from the System's more regular information sources.

The starting point for the current review is best described as a flexible inflation-targeting framework based on the 2012 Statement on Longer-Run Goals and Monetary Policy Strategy.⁵ This "consensus statement" has been reviewed and updated at the Committee's January meetings every year before the beginning of the current review, and it generally articulates the framework in place at the beginning of the review.⁶ First, the statement elaborates on the elements of the dual mandate: It clarifies that inflation over the longer run is largely the Committee's choice, whereas the maximum level of employment is primarily determined by nonmonetary factors. It specifies an explicit numerical inflation objective and defines symmetry around this objective in terms of intent by stating that persistent deviations of inflation from 2 percent in either direction would be of concern to the Committee. Providing a corresponding numerical estimate for the employment leg of the mandate is considerably more challenging because assessments of the maximum level of employment "are necessarily uncertain and subject to revision." Moreover, maximum employment is a multifaceted object, and the statement's solution to providing a numerical value for that side of the mandate is to point to the median estimate of the longer-run normal rate of unemployment in the FOMC's SEP. Having specified the objectives, the statement describes the balanced approach the Committee applies in addressing deviations of employment and inflation from their goals when those deviations imply conflicting policy actions, using language somewhat reminiscent of a symmetric loss function. Finally, the statement acknowledges that the Committee's policy decisions reflect not only its longer-run goals and medium-term outlook, but also "its assessment of the balance of risks, including risks to the financial system that could impede the attainment of the Committee's goals."

The full set of elements within the flexible inflation-targeting framework have evolved since the GFC and the Great Recession. In particular, the use of FG and BSP evolved in the wake of the dual crises. The Committee confronted significant uncertainty about the efficacy and costs associated with these alternative tools as it used them for the first time during this period. In the decade since, the Committee has resolved some of the uncertainty about both efficacy and costs, although, of course, substantial uncertainty about them remains.

For the purposes of this MPF review, we use as a working definition of the pre-review flexible inflation-targeting framework (1) the principles contained in the Statement on Longer-Run Goals and Monetary Policy Strategy, as amended effective January 29, 2019; (2) tools that include those the Committee has already deployed in pursuit of its goals—that is, (nonnegative) interest rate policies, FG, and BSP; and (3) a "bygones be bygones" approach that does not contemplate deliberate overshooting or undershooting in response to deviations from the 2 percent inflation objective.

Good institutional practice suggests that routine self-evaluation is healthy for any organization. By the time of this framework review, however, a fresh look had become particularly important because changes in the economic environment had raised the question of whether the current MPF (as defined earlier) would continue to serve the Committee well in addressing future downturns, especially downturns that might entail prolonged stays at the effective lower bound (ELB).

The particular structural features of economy that directly informed the framework review, and that are discussed in more detail in the staff papers, are as follows:

• The decline in the neutral real rate of interest (r*) and uncertainty about its future level and trajectory. Together with a 2 percent inflation target, a persistent reduction in r* implies less "policy cushion"—less leeway to lower the federal funds rate in the event of a downturn—and thus a greater likelihood of hitting the ELB. As a consequence, one goal of the MPF review was to attain greater confidence that the Committee has the tools to stabilize the economy and to achieve its goals when the frequency of ELB episodes is likely elevated.
• Inflation has persistently fallen short of the Committee's 2 percent inflation goal. Though measures of inflation expectations are imprecise and sometimes contradictory, the persistent shortfall of headline inflation relative to target has arguably led to some slippage of long-term expectations below the Committee's inflation target. Low long-run inflation expectations may in turn slow the progress of actual inflation toward 2 percent. For this reason, the Committee desired to explore tools that are likely to more quickly return inflation to target (or above) after a downturn, reducing the likelihood of an erosion in long-run expectations.
• Apart from expectations, the process governing inflation appears to have changed in recent years. Estimates of the natural rate of unemployment, which are always highly uncertain, had declined significantly by the time of the framework review—perhaps by as much as 1 percentage point. The COVID-19 pandemic crisis has brought renewed uncertainty to estimates of the longer-run course of the natural rate, with highly uncertain effects on the longer-run course of the natural rate. The relatively rapid change in natural rate estimates, coupled with the intrinsic uncertainty of such estimates, makes the use of the estimated natural rate as a guide to policy even more fraught than it has been historically.
• In addition to uncertainty about the unemployment rate consistent with the FOMC's employment mandate, it has become clear that inflation is considerably less responsive to activity gaps (a "flatter Phillips curve"). Many models interpret the reduced sensitivity as, at least in part, a structural feature of the economy—that is, the true coefficient linking inflation to activity gaps in structural models of the economy is lower—though it is possible that this reduced sensitivity is instead a reduced-form implication of the success of the Fed in reducing inflation and anchoring expectations at (or near) its explicit inflation objective.⁷ In either case, less certainty about inflation's response to monetary policy actions makes the future trajectory of inflation at any point more uncertain. Importantly, a flatter Phillips curve may make it more difficult to move inflation toward its target, from above or below. This structural feature and the uncertainty around it may complicate the return to target inflation in the wake of a recession. A flat Phillips curve may also hinder the ability to "overshoot" or "undershoot" the inflation target in some of the "makeup" policies, an issue that some of the review papers discuss.

Altogether, these recent changes in key structural features of the economy—which are assumed to be fairly persistent—provided ample motivation for the MPF evaluation, even before the recession and significant economic disruptions created by the COVID pandemic.

In thinking about the staff work and Committee deliberations about the MPF, it is useful to distinguish between two types of changes that were considered as part of the framework review. The first type of change centered on the question of whether the tools deployed since the financial crisis—interest rate policy, FG, and BSP—might be implemented somewhat differently, perhaps including the use of yield curve control or negative interest rate policy, while remaining within the guardrails of the existing framework (that is, without attempting to move inflation away from its target to compensate for accumulated target misses). The motivation for such changes might come from the lessons learned about the efficacy of these tools, as well as the costs associated with their use, during the period since the GFC. As Chair Bernanke emphasized, the post-crisis period was a time of learning-by-doing regarding the use of FG and BSP, during which the Committee continually advanced its understanding of BSP and FG based on its experience with these tools.

The second type of change to the framework would entail changes in the strategy for addressing deviations from stated objectives (independent of the tools deployed). Throughout the framework review, the 2 percent inflation goal was taken as given, but the bygones-be-bygones approach to deviations from that goal was not. More specifically, the framework review explicitly included consideration of alternative strategies that would allow for policies that in some circumstances intentionally move inflation away from the 2 percent inflation goal. Such intentional departures from the inflation goal lie at the heart of "makeup" policies that promise overshooting (and possibly also undershooting) of the inflation goal, including average inflation targeting, price-level targeting, and variants of these strategies. Examples of such policies are discussed briefly later, and in more detail in the papers supporting the MPF review.

The sequence of papers prepared for the MPF were intended to provide the Committee a foundation for (1) assessing the prospective performance of the flexible inflation-targeting framework; (2) exploring the need for and desirability of modifying the framework; and (3) examining issues bearing on robustness of conclusions to alternative assumptions, and complications with implementation, that the Committee needed to tackle in its deliberations. Throughout, the material provided to the Committee drew on historical experience in the United States, the experience of other central banks, and model-based analysis.

The first two papers of the review sequence—"Monetary Policy and Economic Performance since the Financial Crisis" and "Monetary Policy Tradeoffs and the Federal Reserve's Dual Mandate"—were designed to assist the Committee in assessing what lessons to draw from the post–Great Recession period about the use of its tools and any possible limitations of its flexible inflation-targeting framework.⁸ It is important to recognize that the set of tools that are by now considered part of the FOMC's standard toolkit were "under construction" during the recovery—new and untested and clouded in uncertainty. But, looking back over the course of the recovery with the benefit of hindsight, this first set of papers ask if there are ways in which those tools could have been used even more effectively within the framework as it was currently defined. Further, the papers ask whether there were instances when the framework constrained the Committee from achieving its price-stability and employment goals.

It is critical in examining the post–Great Recession history that we recognize the evolutionary understanding of the structural changes in the economy discussed earlier, and that we understand how those changes and our evolving recognition of them complicated monetary policy decisions over that period. The second paper, in particular, focuses on the policy challenges and tradeoffs posed by these structural changes. A key goal of that paper was to frame a discussion of how well the existing framework had allowed the Committee to manage the risks arising from uncertainty and learning around u* and r*, the flattening of the Phillips curve, and the potential interactions among them.

The second set of papers—"Strengthening the FOMC's Framework in View of the Effective Lower Bound and Some Considerations Related to Time-Inconsistent Strategies," "Alternative Strategies: How Do They Work? How Might They Help?" and "How Robust Are Makeup Strategies to Key Alternative Assumptions?"—introduced two fundamental questions designed to inform subsequent discussions.⁹ First, looking forward, in light of the challenging structural changes already noted, is the flexible inflation-targeting framework likely to be effective in confronting the challenges of making sustained progress toward the 2 percent inflation goal and responding to potential ELB episodes? Second, how do some widely discussed alternatives to that framework work, and how might they help overcome these structural and environmental challenges in pursuit of the Committee's goals?

The second and third papers in this set focus on strategies that are variants of so-called makeup strategies, "so called" because they at times require the Committee to deliberately target rates of inflation that deviate from 2 percent on one side so as to make up for times that inflation deviated from 2 percent on the other side. Price-level targeting (PLT) is a useful benchmark among makeup policies but also represents a more significant and perhaps undesirable departure from the flexible inflation-targeting framework compared with other alternatives. "Nearer neighbors" to flexible inflation targeting are more flexible variants of PLT, which include temporary PLT—that is, use of PLT only around ELB episodes to offset persistently low inflation—and average inflation targeting (AIT), including one-sided AIT, which only restores inflation to a 2 percent average when it has been below 2 percent, and AIT that limits the degree of reversal for overshooting and undershooting the inflation target.¹⁰

Both PLT and AIT strategies imply promises of above- or below-target inflation in the future, possibly under quite different economic conditions, and likely with a different set of Committee members than those that implicitly or explicitly originally committed to the makeup policies. As a consequence, under these makeup strategies, credibility, commitment, and issues related to time consistency take center stage. As emphasized in the first paper in this group, although the Committee used FG during the recovery, it never committed to deliver inflation that departed from the Committee's target. In sum, time-consistency issues are a prominent consideration when makeup strategies are a key feature of a policy framework.

The third set of papers—"Issues Regarding the Use of the Policy Rate Tool" and "Issues in the Use of the Balance Sheet Tool"—return to the first of the framework questions posed earlier: What is the current state of understanding about the use and efficacy of interest rate policy, FG, and BSP, especially near or at the ELB?¹¹ These papers focus on possible ways to evolve the use of the FOMC's tools in a future downturn, such as the choice between date-based and state-based FG, as well as alternative approaches to BSP, especially quantity-target versus rate-target BSP. Yield curve control and negative interest rate policy are among the alternative approaches considered in these papers.

As indicated, the first three sets of papers focus on flexible inflation-targeting (anchored on 2 percent inflation) and its alternatives, and lessons learned regarding the tools (both tried and untried) available in pursuit of the FOMC's goals. Those analyses, however, left several important aspects relevant to the framework review largely unexamined. Those elements encompass issues such as the measurement of the natural rate of unemployment, and the distributional and financial stability aspects of policy. In addition, though the review explicitly took the 2 percent inflation goal as given, tolerance for some amount of deviation from this target (for some amount of time) has not generally been articulated. Given the long period of time over which inflation has fallen short of the 2 percent goal, the question of whether some target range might be preferred to a strict point goal seems particularly salient.

The final set of papers include staff work on these issues.¹² "Unemployment Rate Benchmarks" discusses several concepts frequently used by policymakers for assessing the current state of the economy. "Distributional Issues for Monetary Policy Strategy" emphasizes the differential effect on different populations that are associated with the frequency and duration of economic downturns and the severity of episodes at the ELB. This aspect of economic fluctuations was clearly indicated by the Fed Listens outreach events. One of the key messages from these gatherings was the depth of concern about opportunities and the exposure of workers who had gained during the long period of expansion to a reversal of fortune in the economy—concerns that have proven well founded as lower-wage employees have been disproportionately hit as a result of the pandemic-driven recession.

The paper titled "Monetary Policy Strategies and Tools: Financial Stability Considerations" analyzes the financial stability implications of the monetary policy strategies and tools considered under the framework review, and it discusses the key aspects of a low interest rate environment that influence the interaction between monetary policy and financial stability. In particular, this paper considers the financial stability implications of the structural reality of low interest rates, the possible stability implications of alternative policy frameworks, and the roles that can be played by macroprudential policies and FOMC communications in addressing stability issues that might arise. Finally, the benefits and costs of various concepts of inflation target ranges are covered in "Considerations Regarding Inflation Ranges."

The staff papers described in this brief, now available to the public, were written to establish a firm foundation for Fed policymakers' refresh of their policy framework. This work drew on hard-won experience, the best available research, and the important input of the stakeholders who ultimately bear the benefits—and, we are aware, the costs—of FOMC decisions. Throughout this series of papers, robustness is a major theme. The hope is that this foundation is strong even in the face of the events that were not even imagined as this project started.

References

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Arias, Jonas, Martin Bodenstein, Hess Chung, Thorsten Drautzburg, and Andrea Raffo (2020). "Alternative Strategies: How Do They Work? How Might They Help?" Finance and Economics Discussion Series 2020-068. Washington: Board of Governors of the Federal Reserve System, August.

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——— (2009a). A History of the Federal Reserve, Volume 2, Book 1: 1951–1969. Chicago: University of Chicago Press.

——— (2009b). A History of the Federal Reserve, Volume 2, Book 2: 1970–1986. Chicago: University of Chicago Press.

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