Fed Is Urged to Rewrite Its Playbook
Posted January 9, 2018 8:59 p.m. EST
Updated January 9, 2018 9:04 p.m. EST
WASHINGTON — In the wake of a deep economic crisis and a disappointingly slow recovery, a growing number of experts, including some Federal Reserve officials, say it is time for the Fed to consider a new approach to managing the economy.
Since the mid-1990s, the Fed has focused on keeping inflation slow and steady, at about 2 percent a year, in the belief that it was the best way to nurture economic growth and avoid painful downturns. Those pushing for a new approach do not agree on the best alternative — the ideas range from minor tweaks to tossing the current rule book — but there is broad agreement that the Fed should seize the moment now, before the next crisis hits.
“Monetary policy has not been as successful as we might like over the last decade,” Christina Romer, an economist at the University of California, Berkeley, said this weekend at the annual meeting of the American Economic Association in Philadelphia. “Now really is the time for every monetary economist to say, ‘Is there something better?'”
The stakes are high: The Fed pursues its goals by raising and lowering borrowing costs to influence economic growth and stability. Effective management allows the economy to prosper: Employment grows, wages rise and people enjoy better standards of living. Mistakes cause recessions.
The Fed has faced questions about its methods in the decade since the 2008 crisis, but in recent weeks, officials have shown a willingness to welcome the debate. John Williams, president of the Federal Reserve Bank of San Francisco, said it was time to talk about approach because the Fed is finally wrapping up its response to the last crisis, which entailed unprecedented steps to lower borrowing costs and get financial markets moving.
“The right timing of this debate is really now because the U.S. economy has fully recovered from this recession,” Williams said.
Patrick Harker, president of the Federal Reserve Bank of Philadelphia, told attendees at the economics gathering in Philadelphia that there was an urgent need for more and better research on the available alternatives.
“The most important issue on the table right now is that we need to consider the possibility of a new economic normal that forces us to re-evaluate our targets,” he said. “It is a question for the profession itself, and we do need people thinking about this.”
The Fed’s current approach is known as inflation targeting. It works in large part by training the public to expect a certain level of inflation, disciplining the pricing decisions of businesses and the wage demands of workers. It is, in other words, a self-fulfilling prophecy.
The Fed announced in January 2012 that it would seek to keep inflation at a 2 percent annual pace, formalizing its implicit target since the mid-1990s.
The rise of inflation targeting reflected a consensus among academics and policymakers that central banks did not have direct control over broader economic performance but did exercise direct control over inflation, and that keeping inflation low and stable was the best way to support growth.
Most central banks in developed nations similarly target a low rate of inflation, taking the view that unpredictable increases in prices are economically disruptive. The European Central Bank, for example, aims to keep inflation “below, but close to” 2 percent.
But the Fed’s focus on inflation in the real economy did not prevent asset prices like mortgage-backed bonds from soaring to unsustainable heights before 2008, and concern about keeping inflation low limited the scope of its post-crisis stimulus campaign.
Moreover, the combination of low inflation and modest growth has left the Fed with little room to respond to future downturns by reducing interest rates. During past downturns, the Fed lowered rates by an average of 5 percentage points. But the Fed’s bench mark rate currently sits in a range between 1.25 percent and 1.5 percent. That would make cutting the rate a less effective tool than in previous firefights.
Janet L. Yellen, the Fed’s outgoing chairwoman, has emphasized that the Fed has other weapons in its arsenal. After 2008, the Fed bought large quantities of Treasuries and mortgage bonds and promised to keep interest rates low for years at a time, encouraging borrowing by businesses and consumers.
Yellen is expected to be succeeded by Jerome H. Powell, a Fed governor who is awaiting Senate confirmation as the next Fed chairman.
Some outside economists say the Fed is putting a brave face on a bad situation.
“We are living in a singularly brittle context in which we do not have a basis for assuming that monetary policy will be able as rapidly as possible to lift us out of the next recession,” said Lawrence H. Summers, a Harvard University economist and former Treasury secretary.
The proposed alternatives to inflation targeting can be sorted into two categories. The first contains one simple idea: The Fed should permanently embrace higher inflation. The second is full of complicated ideas for temporarily embracing higher inflation during downturns.
Olivier Blanchard, a fellow at the Peterson Institute for International Economics who began his term as president of the American Economic Association at the Philadelphia meeting, said the choice of a 2 percent target had no particular economic logic to recommend it. Raising the target to 4 percent would give the Fed more room to operate without significantly larger economic costs, he said. Many economists, however, are wary of the simple solution.
Ben S. Bernanke, the former Fed chairman, has warned that the costs of dropping a new anchor would be significant. On Monday, at a Brookings Institution conference convened to discuss alternatives to the 2 percent target, Bernanke dismissed a 4 percent target as politically untenable.
“The Fed is not going to adopt a 4 percent inflation target,” he said. “It’s just not going to happen.”
But Bernanke has added his name to the list of those seeking an alternative to the current system. Last year, he proposed that the Fed should announce that it would temporarily tolerate higher inflation during future economic recoveries.
A mechanized version of that idea, popular in some academic circles, would instruct the Fed to target an alternative economic measure, nominal gross domestic product, or NGDP, which sums inflation and real economic growth. Under a 4 percent NGDP target, for example, the Fed would aim for a combination of inflation and growth that equaled 4 percent, such as 2 percent inflation and 2 percent growth. During a period of lower inflation, like the last decade, such a target would require the Fed to dictate more aggressive stimulus.
Some are skeptical that the Fed can improve the economy by trying harder. Atif Mian, an economist at Princeton University, has argued in his research that high levels of household debt are limiting the impact of monetary policy because many households cannot or will not continue to borrow.
“There is this implicit assumption that things will have traction if you just push hard enough,” Mian said. “But what is the mechanism through which this will raise actual GDP?” Indeed, the Fed and other central banks have not even succeeded in hitting their 2 percent targets in recent years, for reasons that remain unclear. Inflation in the United States has been below that level for the last six years, although most Fed policymakers continue to predict that higher inflation is around the corner.
Romer said more ambitious targets might encourage central banks to try harder to stimulate inflation.
In practice, she said, the Fed could have purchased more Treasuries and mortgage bonds as part of its response to the crisis, or even engaged in direct lending to businesses.
“We should not just assume that what we’ve done for the last 25 years is right,” she said.