How To Get Back On Track: Toward a Monetary Policy Strategy | Hoover Institution

[Music] we're at our next to last session very important session towards a monetary policy strategy we have four excellent speakers two currents to formers and what more could we ask for we'll have a good discussion anyway we're going to start with Jim Bullard who's president of the St Louis Federal Reserve Bank Phil Jefferson who's you can't say too much I guess is Governor from the federal airport and Jeff Locker in Charlie Placer so we'll go in that order so take it away Jim okay thanks very much and thanks for having me uh today I'm happy to talk about many of the themes I've already been discussed today this is called the monetary fiscal policy mix the Central Bank strategy uh so I will emphasize the fiscal elements uh that will that have been uh talked about in the way I like to look at them anyway uh in these slides um so the basic outline of this talk is that the pandemic fiscal monetary response created too much inflation and I think that's uh something we can elaborate on here and to eliminate this excess inflation the fiscal monetary response has to be countered and I'm going to argue that that's actually happening uh as we speak uh in particular I'll argue that the fiscal stimulus is receding and that the monetary policy stance has been adjusted rapidly in the last year to better align with what I would call traditional Central Bank strategy something more like Taylor rule um accordingly I think there's prospects for continued disinflation in the U.S that are reasonably good vote not guaranteed I have to be sure to say that so let's talk about the fiscal monetary response as a starting point uh here um I think has been alluded to here that uh you may want to think in terms of more in terms of Sergeant when you're thinking about this topic think of the pandemic as a global war that induced large-scale deficit spending combined with accommodative monetary policy and I would remind all of you that the spirit of the pandemic response was to err on the side of doing too much as opposed to too little to respond to the pandemic the idea was that you didn't want the pandemic to also damage the economy and leave you under producing for 10 years or something like that so we want to do too much rather than too little but you could also think of that as risking a high inflation regime as the monetary Authority is not offsetting the huge fiscal impulse that's occurring uh that's on uh Unleashed by the fiscal Authority so uh I think it's also important to think of government spending generally in terms of what it's used for and here it was used for transfer payments to disrupted workers and businesses uh that shows up as a sharp increase in personal saving relative to Trend which I'm going to put in the uh chart here in just a moment and I'd stress that fiscal action of this magnitude was unprecedented in U.S post-war macroeconomics so if you're trying to map uh what has happened after the pandemic into previous recessions or the post-war era or even to some extent across countries in the post-war era you're probably going to miss the mark because uh this one had this huge fiscal impulse associated with it and meanwhile the monetary policy reaction to the pandemic was to lower the policy rate sharply which was accommodating uh the deficit spending so this sounds like uh the kinds of things that happened during wartime there's some kind of social emergency uh like a War the government goes out borrows a lot to finance the war the central bank has asked to accommodate that with low interest rates we know that that combination has caused inflation in many different times in places across macroeconomic history so it's not surprising really that we got substantial uh inflation out of that combination of policies so here's the picture uh this is the monetary fiscal response to the uh to the pandemic this goes from uh 2016 on the left over out to the present on the right uh the Gold Line is the effect of federal funds rate uh on the right hand graph a right-hand scale the Blue Line Is the personal savings rate relative to a pre-pandemic trend which is the dotted Blue Line there and then the pandemic itself is the pandemic recession itself is the gray area in the middle so you can see as the pandemic comes on uh you get this very sharp response both of fiscal and monetary policy the Blue Line shoots up and simultaneously the Gold Line uh goes down to zero so this is the nature of this particular episode it was very sudden a very sharp reaction you can see on the left hand scale that you're talking uh hundreds of billions of dollars every time the Blue Line Peaks and the blue line stays above the uh trend line for many months here more than a year and then goes below the trend and I'll talk about that in just a moment so that's the monetary fiscal response you should think of that like oh there's some similar response to a war we did have the paper by George Hall and Tom Sargent here last year talking about the financing of three Global Wars World War One World War II and the pandemic so uh it led to substantial inflation and I've just brought in the Atlanta feds inflation uh tracker here uh maybe just to make some side points uh as as well as uh just pointing out that we got a lot of inflation these are measures of underlying inflation in the Atlanta fed's chart here which they maintain on their website and uh all the measures of underlying inflation so they're kind of kicking out extremes you're throwing out food and energy in various ways these are all these different measures of inflation and this shows the middle column shows what the inflation rate was on a 12-month basis in April of 22 and the last column shows where we are today on all these measures so you can see uh I think it's kind of interesting that five of these nine are actually higher today than they were a year ago sort of belies the idea that we've got inflation on a clear disinflationary path you look at core pce inflation there it's it was five percent a year ago now 4.6 percent that's the committee's favorite measure but some of these other measures uh the San Francisco fed cyclical core PC you know up substantially from where it was last year uh Cleveland fed median CPI up substantially from where it was last year and Atlanta fed sticky CPI up substantially from where it was last year so it's not if you had a really good disinflation going in the U.S economy all these measures would be down all nine of them would be down uh from where they were a year ago that's not happening so far are but our favorite measure is down slightly Bell's fed trim mean which is my favorite measure is actually up from where it was a year ago about 80 basis points so um what has to happen if you have a major social upheaval you have a big fiscal impulse you have a monetary uh accommodation of that impulse what has to happen well you have to switch back to the pre-war uh policy um uh so we want to go to the pre-pandemic monetary fiscal regime the featured inflation near Target so whatever was going on pre-pandemic it seemed to be working a lot better uh than what went on during the pandemic with respect to inflation so is such a switch occurring and I'm going to argue that it is the fiscal stimulus in particular have been fading as the personal savings now below the pre-pandemic trend line it's not quite faded completely because the area above the trend line on the chart is still more than 400 billion larger than the area below the trend line so this is the same picture we had point before again you're talking about a very large program fiscal program here directly more or less to households that's what this is saying the green area about 2.1 trillion excess Savings of which the red part there 1.6 has been burned off but that still leaves you with a half a trillion to go so there's there's still something here in this fiscal stimulus was certainly fading compared to where it was and it does take quite a while we're out three years here and it's not not quite totally extinguished uh but I think this is uh fading and then uh on the monetary policy side we would have to switch to a sufficiently restrictive monetary policy I've got a bunch of slides about that so when you think of Sergeant uh the ends of four big inflations uh which I think is one of the best papers of the 20th century in macroeconomics you know in those papers and the four uh hyperinflationary economies post World War One the inflation ended on the day that uh the fiscal reform occurred in jointly with the monetary reform so it's a particularly dramatic example of the credible regime change all happening right at the same time we don't have that uh not everything isn't happening quite all at once on the same day but it is happening and uh a big part of that was U.S monetary policy in 2022 which has moved us much a much better position than we were one year ago when we met here at Stanford so uh my approach to this is to have a tailor type monetary policy rule with generous assumptions which will give us a minimal recommended value for the policy rate given current macroeconomic conditions so the generous assumptions means that it's going to favor a lower assumptions that would favor a lower policy rate if we're not quite so generous in our assumptions about our Taylor type rule we'll get a higher recommended policy rate that'll give us an upper bound and then there will be a Zone in between the lower bound and the upper bound we're going to see whether we're in that zone or not it's going to turn out that we are we're not going to talk about balance sheet policy in this talk I have talked about that elsewhere um why do we like Taylor rules uh partly because John's sitting right here uh how can I do it uh I I just put the slide in here I think uh uh they're particularly useful when you're away from the zero bound and you have an inflation issue uh there I think uh they've been used around the world to uh allow central banks to hit a credible inflation Target so also they've been evaluated in a large literature and been argued as was said this morning have been argued to characterize close to Optimal policy in commonly used macro models uh I do want to stress that uh Taylor rules also address the long and variable lag argument you you have your model your model has all kinds of lag structures and all kinds of things going into it you put your tailor type rule in and you optimize the coefficients in that Taylor rule for that particular model that's telling you where the policy rate should be at each date and so it's taking into account all the leads and lives that are going on inside the model so I think that there's been confusion over this issue about long and variable lags uh the uh the whole idea is that it's a linear feedback rule based on the state of the economy as it is today and uh so you're you're already uh taking this into account so I don't think it's fair to say um I don't have to be as high as you think I have to be today because uh later on I'll be able to lower the rate uh to where I am today so therefore I don't have to do anything I think those are convoluted uh arguments so uh I also think Taylor rules help you Center the debate they help you think about okay well why do you think uh certain policy rate is the right one okay I'm going to put together uh the the list of ingredients for my Taylor rule then we can argue about whether those are the right things or not and we're going to do that right here this is the Taylor rule specification I'm going to use it does have a Max operator here uh to keep us uh from going below zero uh and a very standard looking uh uh Taylor rule based only on the output Gap um the output Gap term is currently positive so we're going to take the minimum of the output Gap in zero so we're just going to zero that part out uh why are we doing that the the fom sees uh framework states that the policy decisions must be informed by assessments of shortfalls of employment from the maximum level so if the labor markets are working fairly well we're not gonna We're Not Gonna uh take too much signal from that with the flat Phillips curve might as well just zero that part out allow the labor market to be performing well uh we're not going to have a higher policy rate just because of that so uh the generous rule is going to have uh three assumptions in it we're going to measure the inflation Gap using the Dallas fed trim mean PC inflation rate which is one of the uh ones that's relatively low compared to some of the other measures that we could use we're going to use an approximate pre-pandemic value for the real interest rate of a shocking minus 50 basis points but I'm going to argue that that one fits the data better pre- uh pre-pandemic and then we'll use a relatively low value of 1.25 for the parameter describing the reaction of the policy maker to deviations of inflation from Target then we want a less generous tailor rule where we don't make those assumptions quite as nicely to uh to give lower policy rate recommendations so for this we'll use core uh PC inflation as the inflation measure we'll use a higher value for the real uh interest rate one that would come from upholstering Lubbock Williams of about plus 50 basis points or so and then a larger parameter 1.5 which is closer to the literature uh to describe the reaction to inflation deviations so do we get is the current policy rate which has just been moved above five percent is that sufficiently restrictive so the chart is going to say that a couple things which I'll emphasize when I get to the Chart but the the first of all this idea that the policy settings were about right pre-pandemic so pre-pandemic you had output growing uh kind of close to potential you had inflation a little bit under Target uh and you had no projections of anything changing so you could argue that you were on the balance growth path uh pre-pandemic so that's a good kind of Benchmark to Anchor uh what we're thinking about here Mount hairy policy clearly behind the curve last year at this time which will show in the picture but now we're at the low end of what is arguably sufficiently restrictive given current macroeconomic conditions and finally The Zone itself can move in reaction to incoming data so here's the picture so the zone is the gray area the upper bound the little dotted uh Gold Line the Morse uh dashed Gold Line is the lower bound with the generous assumptions this goes back to 2019 pre-pandemic so first of all you can see and the go the blue line is the actual policy rate so you can see first of all that pre-pandemic we're actually in this zone so this is a way to Anchor how we're thinking about this that uh you know policy was pretty good at that point seemed to be about right according to this calculation uh and and so it makes sense the pandemic comes along of course we go down to zero uh but the zone you can see moves up in 2021 as has just been discussed uh at length uh whereas the blue line does not move up until 2022 so uh clearly behind the curve with respect to the policy rate uh last year at this time and I did talk about this picture last year but now we've come up dramatically uh during 2022 and the committee did work very hard on uh uh monetary policy during the year of 475 basis point increases unprecedented in the post-war era I also think we communicated uh ahead of time that we were going to move and we're going to move fairly quickly I would say that most entities around the country adjusted pretty rapidly and pretty well to the increase in interest rates um because they knew it was coming I don't think you can expect every single entity to adjust perfectly to increase in policy rate of that magnitude but um but I do think the communication uh was forthright and direct so now you get over to the right hand part of this chart medium projection for 2023 for the March SCP 5.1 to 5 percent looks like it'll be in this Zone once this Zone gets updated to the right in this chart so now the maybe the bad news for the Hawks in the room here is you're barely in this Zone I made a lot of generous assumptions uh but I think you've moved to a point where we could consider this sufficiently restrictive and in conjunction with the fiscal part of the policy fading uh it looks like we're making the switch to the pre-pandemic uh policy regime on policy inertia there's no inertia in this policy rule um I regard the inertia to be a judgment made by the committee about how fast to go in a particular situation you could always put a ton of weight on the inertia part of the rule and it would tell you to adjust extremely slowly you could put no inertia at all and it would tell you to adjust immediately so I think that part is uh is a judgment call the committee did move quite rapidly in 2022 which I think was a good thing and gives us the best chance of getting inflation back down to Target relatively quickly so now we have prospects for disinflation so far core PC inflation has declined only modestly from the peak levels observed last year uh however I do think that there isn't there are encouraging signs that the switch from the fiscal policy mix uh during the pandemic to the pre-pandemic fiscal monetary policy mix is working and I would take market-based inflation expectations as that signal those expectations were near two percent in the first quarter of 2021 when there was no inflation and no inflation predicted or expected by markets um after I think there was a period of uncertainty in markets whether the FED would actually get its act together and whether this uh switched to a different fiscal policy would occur but now after two two years or so these expectations have returned to levels consistent with two percent inflation so this is the picture that I like on this um you can this goes back to January of 2021 and out to the present in January of 2021 there was no measured inflation and no one was expecting inflation and you could see the two-year The Five-Year and the five-year forward inflation expectations all slightly above two percent which is considered consistent with the two percent inflation Target on PC inflation then in the middle of this picture uh things blow up some um and there is I think points at which it wasn't clear especially in the first half of 2022 in the middle of the picture where it appeared like uh expectations might run out of control and therefore inflation in the US might run out of control but the committee took a very sharp action during the summer of 2022 especially and you can see expectations came back down and now on the right hand part of this chart we're back to levels that are consistent with the uh two percent inflation Target on PC inflation so this I find very encouraging um the committee has taken sufficient action to keep expectations under control and uh prospects are that actual inflation will follow behind uh inflation expectations and return to the two percent Target so I'll stop there uh the uh the pandemic fiscal monetary response created too much inflation it's like a war uh historically speaking we know that this sort of combination creates a lot of inflation across many times and places to eliminate that you have to return to the pre pre-war or the pre pandemic monetary and fiscal policy I think this is happening the fiscal policy uh on the dimension that it matters for this issue is receding and monetary policy has been adjusted rapidly and so I think the prospects for continued disinflation are pretty good so thanks very much thank you thank you good afternoon everyone thank you to the organizers for inviting me to speak it is a pleasure to be here I welcome hearing diverse views on how best to conduct monetary policy and this conference is certainly providing an invigorating debate on that topic before I begin I want to address quickly some news from this morning I am deeply honored by the trust President Biden and vice president Harris have shown me with the nomination to be the next Vice chair of the board I am humbled by this [Applause] humbled by this extraordinary opportunity and thankful to my colleagues friends and family for their support and now I will turn back to our regularly scheduled programming with the standard reminder that the views I will Express today are my own and are not necessarily those of my colleagues in the Federal Reserve System the title of this conference how to get back on track a policy conference is potent it's intent and ambiguity are striking first the title presupposes that U.S monetary policy is currently on the wrong track second the web page for this conference advances a puzzling definition of the phrase on track how so according to the Hoover web page and I'm quoting a key goal of the conference is to examine how to get back on track and thereby how to reduce the inflation rate without slowing down economic growth close quote as this audience knows there are macroeconomic models that permit disinflation with no slowdown in economic growth but the assumptions underlying these models are very strong it's not clear at least to me why such a strict metric would be used to assess real world monetary policy making third the definition of on track in the title contrasts with a more commonplace definition such as quoting again achieving or doing what is necessary or expected close quote as offered by a standard reference such as the Merriam-Webster Dictionary my view is that this commonplace definition provides a more practical lens through which to assess real world policy making against this semantic backdrop I will begin my remarks with my perspective on the current inflation and economic situation then I will consider credit conditions in response to the recent bank stress events next I will offer some normative thoughts about strategic monetary policy making in highly uncertain environments finally I will argue that if you are willing to widen your lens to include a more commonplace definition then it is possible to conclude that current monetary policy is in fact on track current inflation is still high figure one illustrates this point personal consumption expenditure inflation the black line stands at 4.2 percent and core pce inflation the red line stands at 4.6 percent per year in March 2023. Raw news inflation so far this year has been mixed the good news is that food and energy prices both fell in March and total pce inflation slowed to 4.2 percent from five percent in February since peaking last June inflation has declined about two and three-quarter percentage points with nearly all the step down explained by Falling Energy prices and slowing food prices the bad news is that there has been little progress on core inflation to understand why I find it useful to separate to separately analyze three large categories Ted together make up core pce Goods excluding food and energy the red line and figure two Housing Services the black line and services excluding housing and energy the blue dashed line the drivers of inflation in each of these sectors differ somewhat and understanding the different causes and how they affect the different components can help predict the future course of inflation core Goods inflation the red line of figure two has come down since its peak of 7.6 percent in February of 2022. but the most recent news has been discouraging outside of used motor vehicle prices which fell unexpectedly in March disinflation in core Goods prices is occurring as a slower Pace than expected disinflation supply and demand imbalances in the good sector seem to be resolving less quickly than expected core Housing Services inflation the black line in figure 2 surged over the past couple of years as demand in the housing sector underwent a major shift during the pandemic the latest monthly readings have started to slow though that is not yet evident in the 12-month changes shown in figure two the recent snoring was presaged by flattening out events or new leases to new tenants since the middle of last year in contrast core services including housing inflation blue dash line and figure two has not shown much sign of slowing turning to labor markets the April 2023 employment report data continue to point to to a strong labor market amid improvements in labor Supply with the prime Aid labor force participation rate exceeding its pre-pandemic level wage growth has continued to run ahead of the pace consistent with two percent inflation and current trends in productivity growth wage gains are welcome as long as they are consistent with price stability over the 12 months ending in March 2023 the employment cost index for total hourly compensation for private sector workers Rose 4.8 percent down only a little from its peak of 5.5 last June despite strong growth in consumption spending gross domestic product grew modestly an annual weight of 1.1 percent in the first quarter of 2023. as inventory Investments slowed down substantially similar to the below Trend pace of growth in 2022 looking ahead last quarter's growth in consumer spending seems unsustainable indeed after a very Rising after Rising very steeply in January 2023 consumer spending ticked down in February and was flat in March moreover I expect slower consumer spending growth over the remainder of the year in response to tight Financial conditions depressed consumer sentiment greater uncertainty and declines in overall household wealth and excess savings the tightening in financial conditions we have seen in response to our monetary policy actions is likely to be augmented by the effects on credit conditions from recent strains in the banking sector the U.S banking system is sound and resilient the Federal Reserve working with other agencies has taken decisive actions to protect the U.S economy nevertheless it is reasonable to expect that recent stress events will lead Banks to tighten credit standards further even though it is too early to tell my view is that these incremental credit restraints will have a mild retardant effect on economic growth because the recent bank failures were isolated and they were addressed swiftly by aggressive macro and micro Prudential policy actions nevertheless I acknowledge that there is significant uncertainty around the amount of tightening of credit conditions in the coming year in response to the bank stress and the magnitude of the effect that tightening might have on the U.S economy therefore there is some downside risk that the incremental effect of the credit shock is larger than I expect the pandemic aftermath geopolitical instability and banking sector stress have contributed to a highly uncertain economic environment Additionally the numerous postpaid pandemic surprises in inflation employment and economic growth suggests that the underlying structure of the U.S economy may be in flux more simply the data generating process for postpaid for the post-pandemic U.S economy is less clear due to the proximity of the pandemic and its unprecedented disruptions in economic and social activity they are currently insufficient post-pandemic data to identify the parameters and stable relationships that characterize the possible new structure of the economy given this observation what is a reasonable monetary policy making strategy the answer to this question is likely to be different for each monetary policy maker I want to share with you a few strategic principles that are important to me first policy makers should be ready to react to a wide range of economic conditions with respect to inflation unemployment economic growth and financial stability the unprecedented pandemic shock is a good reminder that under extraordinary circumstances it will be difficult to formulate precise forecasts in real times I'll do mandate from Congress is especially helpful here it provides the foundation for all our policy decisions second policy makers should clearly communicate voluntary policy decisions to the public our commitment to transparency should be evidence evident to the public and our monetary policies should be conducted in a way that anchors longer term inflation expectations third and this is where I'm revealing my passion for econometrics policy makers should continuously update their priors about how the economy works as new data become available in other words it is appropriate to change one's perspective as new facts emerge in this sense I am in favor of a Bayesian approach to information processing processing while these principles do not constitute a complete monetary policy framework I think they are useful when thinking about features of such Frameworks by way of concluding I would like to return to the question of whether current monetary policy is on track but allow for The Wider defining lens of achieving or doing what is necessary or expected the national unemployment rate was 3.6 percent in March 2022 when the current monetary policy tightening cycle began today after 500 basis points of tightening of the policy rate the national unemployment rate stands at a near record low of 3.4 percent at this recent Peak total PC inflation was seven percent in June 2022. currently it is 4.2 percent in March 2023. is inflation still too high yes has the current disinflation been uneven or slower than any of us would have liked yes but my reading of this evidence is that we are doing what is necessary or expected of us furthermore monetary policy affects the economy and inflation with long and varied lags and the full effects of Out Rapid tightening are still likely ahead of us we are balancing the directives of the Dual mandate given to us by the U.S Congress this is not an easy task in these uncertain times but I can assure you that I and my colleagues on the fomc take it quite seriously and with great humility it is in this sense that I believe that we are well on track thank you thank you John for the invitation to participate uh in this conference and congratulations on your 30th anniversary I'll be presenting a modest suggestion to improve monetary policy Communications our suggestion was also presented at a meeting of the Shadow Open Market Committee last November and it grew out of discussions last fall uh with Charlie Placer my co-author uh friend former fomc colleague and current somc uh caller colleague the fed's conduct of monetary policy has been covered pretty thoroughly today but the FED has also we believe struggled to communicate effectively there have been notable instances of Market surges seemingly prompted by fed statements that had to be walked back with some later subsequent correction and there appears to be a significant gap between the assessments of Market participants and the committee about the likelihood of various funds rate paths it's not clear that market participants understand what might be required to restore price stability and to the point of Jim bullard's uh charted on expected inflation longer run Market participants May believe inflation will get to two percent but it's not clear they understand what it's going to take in the interest of time um I won't catalog all the fits and starts of fed communication challenges over the last few years I'll just highlight the fed's most recent forward guidance framework it's built on the phrase sufficiently restrictive which appeared in the fomc statements from November of last year through March of this year as you might expect chairman Powell was has been asked several times to explain what this phrase means but I think it's fair to say that his answers have been no more specific than the phrase itself the most recent fomc statement dropped this phrase however leading naturally to questions at the press conference about whether the committee believed policy was already sufficiently restrictive Chairman's Powell answer was that they don't yet know so where would one look for quantitative guidance on what level of interest rates would be sufficiently restrictive to restore price stability the natural answer is to look to historical evidence from times in which the FED successfully reduced and contained inflation discussed this morning systemic policy rules such as those introduced 30 Years Ago by John Taylor summarize in a convenient and usable simple form how interest rate settings varied with incoming data on inflation and unemployment when the Fed was successful at bringing inflation down and containing it the benefits should be familiar to uh from this morning's discussion in addition systematic policy rules have intuitive properties they respond more than one for one with inflation rises above Target so that real interest rates rise and restrain spending encourage deferred outlays and interest rates responsibly to increases in resource utilizations is the same thing defer spending moreover such rules perform well in a wide variety of models so as we watch policy unfolds in the last couple of years particularly last year and as we lot and as we reflected on the communications we we heard from the FED it occurred to Charlie and me that the FED could improve Communications by making explicit reference to systematic policy rules in its discussions with the public policy makers could note that successfully restoring price stability is likely to require policy settings that are broadly in line with times the FED has succeeded in reducing inflation and keeping it under control they could cite the prescriptions of a range of policy rules with different parameter values that align with that past Behavior to it and they could point to a range of policy rules so they avoid policing too much weight on any particular version they could note how current interest rates compare with the range of prop prescriptions and they could point to the fomc's economic projections that are released after every other meeting and cite what these rules prescribe conditional on the fomc's projections they could compare those conditional prescriptions with the fomc's own projections for the funds rate and they could show how those conditional rule prescriptions vary with assumptions about future inflation and unemployment the FED itself publishes several different rules of on in its monetary policy report to Congress and on the board's website and those rules are a routine part as was noted earlier today of the briefing materials distributed to participants before every fomc meeting and this has been going on for a couple of decades and handy do-it-yourself policy rule calculators are available online the Atlanta and Cleveland Federal Reserve Banks I recommend them to you we believe that referring to prescriptions of systematic policy rules in the manner we suggest would improve fed Communications it would provide a better way of conveying how high the committee believes policy rates will need to go to bring inflation down to Target it would have helped particularly last year when the Fed was struggling to get the markets to focus on that as opposed to how big the next move was going to be and more importantly it would help people understand how incoming data is likely to affect the path of the policy rate this strikes us as a better way to convey forward guidance than what the fed's been using and linking policy to an objective evidence-based Benchmark would dampen any potential perception that policy might be politically motivated it should provide a better basis for anchoring inflation expectations so you look at inflation expectations we discussed a lot in the last sentence last session those reflect expectations about the future conduct of the FED that is to say the reaction function underlying the fed's future Behavior and so explaining that better might be the best way or a better way to Anchor inflation expectations than what the FED does now so it's like Andy's first doctor says simply two percent trust us and Andy's more modern doctor the second one he says well look understand a lot of things could happen here's how we're likely to react here's how we'll treat it the second doctor the modern doctor and this is behind the transformation and the way doctors approach this question understand that that's a better way to reassure patients than just saying trust me so uh we're convinced this would be a better approach now it's important to separate the use of policy rules and Communications from actually adopting the rules we're not saying that they this would require them to mechanically follow any given particular rule or turn policy settings over to a computer this has always been something of a strong man to distract and deflect attention from constructive ways the FED could improve Clarity by talking about the implications of policy rules we're not saying the FED should never deviate from the recommendations of policy rules presumably the FED would have some reason for doing so some reason why this time is different things happen we're not ruling that out but transparency would obviously be enhanced if the committee shared their rationale for deviating from what is in actuality past practice why are they why are they deviating from past protocol putting their carts on the table as it were so our suggestion is not about the conduct of policy it's about how they communicate about it the conduct of policy is a separate debate we have we have our views and I don't think you'd even need to buy us a drink to find out just come up and ask so in in his remarks president Bullard demonstrated the type of communication we're talking about he did this twice last year once this conference I understand and then in November exemplary what's striking about President bullard's presentation is how rare that is virtual I know of virtually no other Communications from the Fed speeches public statements testimony that mentioned the Taylor rule that referenced the Taylor Rule and what it how it connects to current policy so I want to share some calculations to show how this communication practice might work what it might look like now table one shows the prescriptions of three representative versions of the Taylor rule through 2025 Q4 the prescriptions for the fourth quarter of 23 24 and 25 use the fomc's median projections for inflation and unemployment on the right hand side of the equation and those projections are shown in the lower panel four quarter inflation Falls you'll see from 4.9 to 3.3 then 2.5 then 2.1 the core pce inflation Falls from 4.7 down to 2.1 over this Horizon as well and and inflation so inflation's back to two percent in 2025. the unemployment rate which was 3.4 percent last month Rises to 4.5 percent in Q4 this year the second column from the left up at the top panel again shows figures for the first quarter of this year the funds rate average 4.1 percent while these three policy rules recommended settings of around seven and a half percent this Gap is a pretty large three percentage points and it's a measure of how far behind the FED has fallen by waiting so long to raise rates the third column for the from the left shows figures for the fourth quarter of this year the median fomc projection at the March meeting was for a funds rate averaging 3.1 percent essentially where they are now and the three policy rules show showing here recommend a funds rate of around four percent then suggesting that policy will indeed be appropriately tight if the fomc stands pet that assessment is predicated however on the fomc's projections that inflation will fall to three and a half percent and the unemployment rate Will Rise by a full percentage point in the next six months essentially this highlights an important source of uncertainty about the near-term course of monetary policy if inflation does fall this year to around the rate the fomc projects the current level of the funds rate appears to be sufficiently restrictive to restore price stability but current levels of the funds rate the current level of the funds rate does not appear to be sufficiently restrictive given current rates of inflation and unemployment and so it's not obvious what force will bring inflation down to the rates the fomc predicts for year end a natural question therefore is how the prescriptions of those rules would vary if things didn't turn out quite so well this year well table two shows calculations Based On A variation of the fomc's economic projections in which the disinflation they expect is just delayed a year we just put it off a year so the changes from the SCP projection in the lower panel are highlighted in both those are the only numbers I've changed inflation for this year remains at first quarter rates 4.9 essentially for headline 4.7 for core inflation then Falls to 3.3 and 3.6 percent respectively for 2024 one year later than the fomc projection the third and fourth Columns of the upper panel showed that these rules prescribe significantly higher levels of the funds rate around six to six and a half percent in the fourth quarter of this year so if we don't get inflation falling down to three and a half percent that's where the funds rate would need to be to be sufficiently restrictive as judged against the pattern of past protocol similarly table 3 shows calculations for an alternative scenario in which disinflation occurs one year later than the fomc projects as in table two plus the job market remains tightly the unemployment rate remaining 3.5 percent through Q4 instead of rising to 4.5 percent two so two simple scenarios in this one systematic policy rules prescribe a funds rate of about seven and a half percent significantly higher than the current rate now these alternatives are not necessarily forecasts that Charlie and I would write down but they do strike us as reasonably plausible given the recent data if the data do come in more consistent with these Alternatives then the fed's more sanguine projections I think Market participants are going to be avidly interested in the implications for monetary policy policy rules could provide a natural framework for the FED to convey a quantitative sense of the likely implications of the the data disappointing them on the high side on the other side if the economy weakens and tips into a reception recession fairly rapidly systematic policy rules can convey a quantitative sense of how much of a pivot is in store so let me close with the broader observation for turning it over to my friend Charlie the FED has often had mentioned this this morning an unhealthy attachment to preserving optionality and that seems to be at the root uh in my mind of their resistance to clear Communications in general in a lot of respects but to policy rules in particular so my hope is that the FED fed policy makers will see it in their interests to clarify things just the way Andy's second generation doctors realized it was better for patients to avoid the risk of just shocking them with a A you know a treatment plan out of the blue so this way the FED I think using policy rules can avoid some of the Market surges that they saw last year that seemed to be driven by just untethered swings and raid expectations and I think they can do this without compromising their own view about policy we've framed this as a Communications strategy not a policy strategy so they could they could move to this without claiming they're adopting Apollo Taylor rule or or without compromising their future discretion it's just a matter of being more forthright um so that concludes my portion of the program Charlie do you want to come up thank you I'm going to try it keep my marshmallows to be brief because of the time but I want to pick up where Jeff left off um what we have and what we're proposed this paper was a modest effort to move the FED in its Communications to a more systematic uh and transparent strategy for monetary policy um I actually propose something like this myself when I was at the Fed in June of 2014 I gave a speech at the Islamic Club of New York which actually proposed something very much like this about how the FED should incorporate systematic rules into their communication and why it would help however I'm only a step further now in my brief remarks to um talk about what has to happen to get the FED back on track so to speak and to achieve a more systematic and transparent approach to policy the FED has resisted steps obviously to limit its own discretion and has for years and years and years and years and years and years and years um uh and it hasn't made a whole lot of progress in changing that that view so they've resisted this this limited limitation on discretion but in doing so they've also limited the ability to hold the FED accountable and to make it more transparent um so the the bigger problem it seems to me is looms out there and it's a tough one it stems from a variety of sources and I just want to mention too one is limiting discretion um maintaining discretion partly to involves a uh a response to many political pressures that the FED is under the FED is supposed to be independent I think um it is losing that Independence and it's deteriorating and that that comes from a couple of couple of aspects of things one is and in 1951 most of you know the Fed there was a 51 Accords which was agreement between the treasury and the FED that the FED would have Independence to determine the size of its balance sheet it gave the Fed ultimate control over determining the size of its balance sheet that was a very important step at the time because um it broke the fat away from interest rate payers that occurred during World War II any long-term Government Bond rates at a very low level there's a very acrimonious battle at some point but nonetheless it happened and they broke the Peg and the Fed was able to determine its own balance each size but times have changed what we see now is obviously the FED can control this balance sheet but the other dimensions under which political pressure can get uh maybe applied is now the FED is heavily engaged in credit policy balance sheet policy from the FED in 1951 the feds balance sheet was almost was entirely government bonds long-term government bonds and petition over time that gradually shifted to more short-term but now the dangers of politicization of the fed or one of the dangers is the use of credit policies to allocate resources across sectors and economy across firms and that has become a much more widely used tool which I think threatens Independence and integrates in some sense or makes that policy less independent and more subject to control by the treasury the whole literature on that much of which I've written about so I want to elaborate on that but things are different now and I think we have to look at Independence in a different light the other point I want to make very briefly is coming up with a monetary policy strategy and the advantage of the Taylor rule our versions of the Taylor rules what we know about them is they're imperiously based they have empirical evidence to back them up they are robust across a very wide range of economic models and they work pretty well in lots of different environments I think John made this point earlier uh this morning um and uh I I think that it's important that we understand that and I want to I think John and maybe Rich refer to Friedman 69 or 68 presidential address this morning I'm going to pick another quote from three months from that same um from that uh saying if I can find it right well I get it right oh I didn't bring it up all right anyway that quote is we are in danger we are in danger of asking monetary policy to achieve roles in China's undertake we are in danger of asking it to achieve tasks that is unable to achieve and in so doing we are putting at risk the contribution that monetary policies can make that was a cautionary note to say be careful of what you ask of central banks and I think we've lost sight of that caution and that wisdom and we are now asking monetary policy and central banks to do all sorts of things that they weren't designed to achieve whether it be in terms of credit policy whether it be in terms of of other aspects we are asking too much of them we need to reestablish the limitations the boundaries and the constraints on monetary policy if we are to achieve both Independence and an affected monetary policy strategy I'll just leave it at that thank you very much thank you Jim your your piece is about monetary policy and fiscal policy and I want to toss out a caution about overstating the amount of foreign fiscal policy stimulus that it's diminishing um three points here um certainly fiscal stimulus is is far less than it was in 2020 and 2021 however President Biden's infrastructure legislation of a trillion dollars um that is starting to flow through the economy we've seen we see it having a large impact on Q4 and q1 G in GDP and that is going to continue to flow for several years a hundred percent of the spending goes into directly into GDP and fiscal analysis historically suggests that that comes with a higher multiplier than transfer payments secondly of the five trillion dollars in budget spending deficit spending Authority um half a trillion was federal grants to State and local governments a hundred percent of that was saved right now state and local governments behind the FED are the second largest holder of U.S treasuries about 750 billion dollars more than pre-pandemic levels that is another um you know three percent of GDP and we know that'll be spent and will be stimulus even Social Security Cola added a Medicare Medicaid snap programs it all adds up to a tremendous increase in nominal disposable income a government spending is important for this purpose if you think that the infrastructure spending is uh legitimately on public capital and that that's improving the productive capacity of the country something we could definitely have a whole conference on but if that's if that's what you think is going on I think that's a different animal than uh borrowing money and putting it directly into bank accounts of a households so that's one on the state and local I agree with you one of the things that I've found in uh anecdotally and talking to people across the district and across the country is that state and local governments are flush they have a lot of spending so it's like you you poured a lot of federal spending you you put it out to these state and local governments but they don't really have the infrastructure to be able to spend it at that rate and so it's trickling out and I think that will come out uh over time so I agree with that uh coal is also an issue but uh but I think this the more immediate issue for monetary policy is the transfer payments I think hey there uh Charlie sigular um we talk a lot about foreign projections and and trying to make all sorts of um forward assumptions and yet the FED gets on a weekly basis uh data on M2 money supply yet we we hardly hear about it and um it's in recent data there's been nothing uh normal about it and two years ago data there was nothing normal about it so I just want to sort of highlight a couple things um from January 1 to of 2020 through December 31st of 2021 money supply grew by 40 percent um which was the highest two-year growth on history there may be something in the 1700s that you know Ferguson May uh see but I've in the data that I looked at there's nothing um at the same time uh Bank deposits grew by 36 percent um by the two note to the tune of about 4 trillion um both money supply and Bank deposits peaked at the same month last year April of 2022 and they've both been in Decline since uh this is uh now there's a year-over-year decline in M2 and Bank deposits which is the first time that I've seen this has ever happened um most recent data shows that money M2 is declining by 4.1 percent annualized which is an all-time low in terms of percentage growth um so just trying to sort through all this and there's a lot of extremes going on here and these fluctuations and I just wonder um if these extreme gyrations reflect or are affecting financial and price stability and is M2 something that the FED should be looking at more closely well I will say this about uh M2 that uh you know I come from the monitors bank and so I grew up as a monitor so I'm very sympathetic um it's been hard to relate um money growth to inflation empirically uh I think that the uh standard thinking around the St Louis fat anyway over the years has been that at low levels of inflation and low rates of money growth there's just too much other noise going on in the economy it's hard to relate money growth to inflation in that circumstance now here you had an outsized movement in M2 and sure enough you got inflation right behind it so maybe monetarism will be reinvigorated by this uh by this episode I would also say if you subscribe to this theory that this is bodes well for uh disinflation uh ahead if that's if that's the way you want to look at it yeah go ahead yeah yeah um I'd commend a a recent piece by Peter Ireland in Forbes released on their website arguing that we need to relearn monetarism something it is to play on some senior officials who said we unlearned it okay we have Bill Bill Nelson and Andy and Christian and Bill now we got to stop bill hi uh Bill Nelson ring policy Institute so I have two questions for the panel uh the first is uh to what extent does the fomc and fed bear some responsibility for the the national turmoil we've been experiencing uh owing in large part to the sharp rise in interest rates that that we've witnessed I I mean I'll I'll acknowledge up front that first and foremost the problems were the responsibility of really awful Bank risk management and we learned a lot about regulation improvements to regulation and supervision but you know it's also true that you know a central bank that is behind the curve raises rates just as much I mean as one that's not a behind the curve but actually by more and more rapidly in that Financial stability consequences is one of the important reasons not to fall behind the curve but it's worse than that uh sorry you know there was also I mean the Fed was actively communicating to the markets you know that neutral policy was two and a half percent at a time when inflation was running at eight percent so for example this is from the July fomc July 2022 fomc meeting this is chair Powell so I guess I'd start by saying we've been saying we would move expeditiously to get to the range of neutral and I think we've done that now we're at two and a quarter to two and a half and that's right in the range of what we think is neutral and there were plenty of common whoever now some commentators and I was one of them saying that's dangerous advice because it's going to cause you know intermediate and longer term rates to to be too low um and uh the second question which is related to that uh which is I'm curious from speak to the panelists to know your current spot estimate of nominal neutral Federal fundry so let's go Indian and Krishna Hindi and Krishna well first of all just thanks a lot to John for organizing this conference and I think this kind of forum is really important for the public to actually have a dialogue one of the things that's been just very troubling to me the last several years is you look at the bank of England they've been facing lots of tough decisions tough judgment calls and there's been Descendants on both sides you can talk to Catherine man she's brilliant she's dissented from some of the decisions she may be right or wrong but she's got an independent point of view and meanwhile the FMC has been kind of this unified I think um maybe Mickey said it earlier kind of circling the wagons View and I I recognize Jim you've been courageous and brave over your career as of Jeff and Charlie plus are all right to sometimes say no I don't agree with that and sometimes you might be wrong sometimes you might be right but to it takes some courage and I just hope that going forward that all of you will will um you know because they're going to be facing tough decisions so I'm really excited that you're going to be a leader in this going forward and I guess my question for you and Jim is Jim kind of presented this thing of well maybe we're just at the very bottom of the of what do you call it the the range the comfortable range of the Stone The Zone okay the in the zone okay but the worry that I have is that what went wrong in the 70s was that in the end if I got so far behind the curve they had to tighten so much we had a terrible recession and it hit ordinary families really hard this is really that it's urgent to to to find a way to bring inflation down without causing that kind of catastrophic damage to the real economy and so Phil you mentioned the Dual band-aid and so I'm just curious for the two of you thinking about risk management where in that zone should we be should we be at the bottom or maybe at the top or somewhere in the middle I mean this comes back to this morning about the Taylor rule as a benchmark so again I really appreciate the two of you helping us to understand your views so Christian that's and then we have the response thanks very much Krishna guha I have a core Partners formerly New York fed uh quick comment a quick question quick comment is uh when we talk about the market whether markets misunderstanding things I think it's illustrative to point out that using the lack of Plaza sort of Benchmark were the world to involve along the lines envisaged in the fomc's SCP then in fact according to standard tailor rule specifications fed funds rate should be somewhere between two and a half and three at the end of 2024 that's what your first slide showed and so it's it's um it's not necessarily obvious that the market is wildly mispriced the market May however be too optimistic throughout the prospects of achieving that inflation path which you rightly Illustrated yourselves in the second set of slides my question has to do with the multiple forms of tightening that are taking place at the moment so we have three forms of tightening underway there's monetary tightening through the classic interest rate Channel this balance sheet tightening and there's some hard to quantify credit tightening taking place so if we were to try to integrate this into a tailor type rule would it be reasonable to enter in some additional terms for those other forms of tightening um if not how should we integrate these into our thinking these last three questions um any are closely related okay one was about um trying to assess the impact of let's call it the credit shot okay the one prior to that had to do with um balancing the Dual mandate one before that was from bill was asking about what was the neutral rate okay so in my mind these the questions are kind of all related to one another in some way and I think that is what makes um monetary policy quite challenging um because I do take the Dual mandate uh very seriously those of you who may know something about my background in terms of my scholarship I've written extensively on poverty and inequality um from a neighborhood in Washington DC where I've seen a very disparate comes uh for people in this Society so I care very much about how the labor market performs because for most people uh in the U.S economy they're standing in the labor market will very much determine their station in life and so that's something I'm very mindful of but I also am aware that inflation is the most Insidious of social diseases and so it's important to try to get it down so that people can go about their lives in a way uh where inflation is in the background so um what makes saying what the neutral rate is in this environment so difficult is that we have multiple things going on okay we do have the credit shock and its impact and that can um impact your thinking so I think it's a matter of public record that um for the banking stocks occurred I would guess and Bill I mean Jim please correct me people on the eflmc had one view of what that neutral rate might have been or The Terminal rate if you want to think about it in that way and the stocks may have had some credit shock we have had some impact on their thinking so whether or not anyone wrote down a tail rule that included the impact of the credit Titan and not um we can't say for sure but I think in terms of policymakers thinking uh it certainly weighs in so you know I I don't have a definite answer to these three questions but I want you to know that um these are the considerations that we're all trying to balance uh as we're looking or thinking about the appropriate setting of the main policy rate thank you Jeff then we have to stop yeah so uh to Bill Nelson um we did cite the pal statement you quoted in our paper noted that uh a month later a month and a half later in August John Williams head of the New York fed gave a city Wall Street Journal where he lays out the right way to think about the neutral rate neutral rate it depends on how you define it like Excel or the SCP you know those are two different questions um is the market off base the question is like what's going to get inflation down to where it is right where it's it's going in the SCP and the Taylor rule says well you know given what we've seen now we're not there it's sort of like a miracle happens in the next three quarters or two quarters now the credit trading point is interesting so the tailor rule summarizes given inflation and unemployment here's where the rate should be now times where the feds had to tighten to reduce inflation it's almost always been associated with some credit tightening virtually every time right so you would only want to adjust the Taylor rule for credit tightening you would only want to forego rate increases that you would other Inc otherwise undertake on the base because of the um presence of credit tightening if you thought the credit tightening was worse than it was typically in the past at times like you know 1990 early 90s 2001 82 right so I it doesn't seem to me like that's warranted now so I don't think you add the term for it here I think we we have to stop is that okay maybe last word for Jim go ahead okay so uh I agree with uh Philip Jefferson the uh unemployment rate is very low 50-year low the inflation tax is high this hurts the lowest uh segment of the population of the income distribution the hardest they have less ability to adjust to the inflation so I think that's our opportunity to get uh inflation down now uh if we can get rid of the inflation tax and while the labor market is strong is the market uh Krishna uh I agree the Market's optimistic they're not necessarily wrong I like to interpret that as they have a lot of confidence in the fomc um I think there are multiple forms of tightening going on you have to put that in a model you can't just put that in your Taylor rule and then on financials Bill Nelson Financial stability did the FED cause the financial turmoil uh I said contribute um I think we did communicate fairly effectively uh that we were going to raise rates quickly and I do think by and large the financial sector agreed that we were going to have to do this they agreed they saw a lot of inflation they agreed that we're going to have to go up quickly you just can't expect every entity in the whole country to adjust uh appropriately and so some probably are going to get burned on this but but I think overall I think it's been pretty good I will stress I will say Financial stress metrics are actually still quite low so we're not in a situation that we were in March April of 2020 and we're certainly not in a situation that we were in 2008 so so far so good uh hopefully we'll get good results out of this okay thank you panel thank you [Music]

Channel: Hoover Institution

Views: 1,661

Keywords: Monetary Policy, Monetary Policy Strategy, Federal Reserve, Banks, Central Banks, Money Supply

Id: 9t3YKCtyCCA

Length: 83min 1sec (4981 seconds)

Published: Tue May 23 2023