Thank you, Peter, for that kind introduction. It is great to be with you here at the UC Santa Barbara Economic Summit. My plan today is to give some prepared remarks about monetary policy, and then I look forward to having a wide-ranging discussion with Peter and Kathy. Before I begin, let me note that my comments reflect my own views and do not necessarily reflect those of others in the Federal Reserve System.
I will argue that monetary policy has been too tight in this recovery, resulting in a slower economic recovery than necessary and low inflation expectations, which directly saps the Fed’s ability to respond to a future downturn. I believe we need to understand what led to these results when we evaluate strategies for conducting monetary policy going forward.
Congress created the Federal Reserve in 1913 and has assigned it goals that we work hard to achieve. We call those goals our dual mandate of price stability and maximum employment. We have defined price stability as inflation of 2 percent per year, and maximum employment essentially means that as many Americans who want to work are able to find jobs. Historically, we have assumed that these goals are connected like a seesaw: As the economy gets stronger, businesses hire more workers and unemployment falls, driving wages up, which eventually leads to inflation. In a downturn, the reverse happens: Firms lay off workers, unemployment rises, and inflation drops. In the medium term, we hope to keep inflation at the Fed’s 2 percent target with unemployment as low as possible. That’s how it is supposed to work.
This year, for the first time, the Federal Reserve is conducting a comprehensive review of the monetary policy strategies we use to achieve our dual mandate. We want to know: Do we have the right approach? Might some alternative strategies better deliver on our twin goals over the course of an economic cycle? Senior Federal Reserve officials will gather in Chicago in June to hear from outside experts as part of this assessment. In addition, each of the 12 Reserve Banks is hosting its own forum to gather input from a broad range of constituents. The Federal Open Market Committee plans to report its findings to the public in 2020.
As I think about this assessment, I believe we must first analyze: How has our current approach to monetary policy delivered on our dual mandate in this recovery? If there have been any shortcomings, then we should ask: Have those shortcomings been caused by the limitations of our monetary policy framework or by the implementation of that framework? What were the costs of any shortcomings? And then, finally, as we analyze potential alternative frameworks, we should understand not only how well they should perform in theory, but also how likely they will be implemented as intended when actually put to use. These are some of the questions I am going to be thinking about in our upcoming review. I now offer my own thoughts on some of these questions.
Let’s start with assessing how our current framework has performed in this recovery. At first glance, it seems like our framework for setting monetary policy has worked well in delivering on our dual mandate goals. Inflation is a little short of target, currently running at 1.5 percent, with core inflation at 1.6 percent. For the past 10 years, both headline and core inflation have averaged 1.6 percent, again somewhat short of our 2 percent target. Meanwhile, the job market is strong, with monthly job gains averaging 205,000 in 2019 and the unemployment rate now at 3.6 percent, a 50-year low.
Upon closer inspection, however, I don’t think our approach to monetary policy in this recovery has provided as much stimulus as the economy required. With optimal monetary policy, the twin goals of price stability and maximum employment should be in tension. Even though the headline unemployment rate is low, given the continued strong job gains with only modest wage growth, it seems clear to me that we are not yet at maximum employment. With inflation somewhat too low and the job market still showing capacity after 10 years, the only reasonable conclusion I can draw is that monetary policy has been too tight in this recovery.
Did this too-tight policy arise because of weaknesses in our framework or because of how we implemented that framework? In my view, the answer depends in part on what time period we are talking about. I will separate the recovery into two distinct periods: the few years after the recession ended, call it the crisis response period of 2010 to 2014, and then the more recent policy normalization period of 2015 to today.
Starting with the first period, the Federal Reserve responded very aggressively to the Great Recession, cutting the federal funds rate from 5.25 percent in September 2007 to 0 to 0.25 percent by December 2008, hitting what we call the effective lower bound. That exhausted the Fed’s traditional monetary policy tool. At that point, the FOMC innovated on the fly, effectively expanding its monetary policy tool kit by embarking on creative, bold, and untested policies of quantitative easing (QE) and forward guidance to try to provide additional monetary stimulus, ultimately expanding the Fed’s balance sheet from less than $900 billion in mid-2008 to $4.5 trillion by October 2014.
Although I am not in favor of rigidly following simple monetary policy rules, I do believe they can be helpful in assessing whether monetary policy is stimulating or restricting the economy. According to analysis from the Federal Reserve Board, the Great Recession called for the federal funds rate to drop to -300 basis points on average from 2009 through 2013,1 using a simple policy rule as a guide. Thus, the effective lower bound was a real constraint on delivering the optimal federal funds rate.
Turning then to QE and forward guidance, translating their effects into an equivalent federal funds rate reduction is highly inexact, but the best estimates we have suggest that they provided another roughly 100 basis points of stimulus.2 Thus, factoring in the effective lower bound, QE, and forward guidance, effectively monetary policy was at roughly -100 basis points following the Great Recession when it likely needed to be -300 basis points. Hence, monetary policy was too restrictive in this period.
It is clear that the Fed’s original framework of only utilizing adjustments to overnight interest rates was insufficient to deal with the Great Recession. To the Committee’s credit, the framework was adjusted and implemented in real time. Could the implementation have been better? With the benefit of hindsight, could QE have been larger or forward guidance have been provided with a firmer commitment? Perhaps. Hindsight is always clearer. But given the experience we have gained with these tools, we should now analyze how much power they potentially could have if used even more aggressively in the future. I also look forward to assessing how other potential frameworks can deal with the constraints of the effective lower bound.
Turning to the more recent period, the FOMC began raising the federal funds rate in December 2015, even though core inflation was 1.3 percent at the time and headline inflation had averaged only 1.5 percent over the previous five years. It is important to note that in 2016, the FOMC clarified that its 2 percent inflation target was symmetric, as opposed to a hard ceiling, meaning inflation could deviate modestly above or below target without causing alarm. With policy having delivered headline inflation 0.5 percentage point below target over the prior five years, I interpret the symmetry of our target to mean that we should have been equally willing to tolerate inflation of 2.5 percent for the following five years. The symmetric target is not a make-up strategy that calls for intentionally delivering high inflation, but, in my view, its tolerance of some above-target inflation reduced the need to preemptively raise rates to prevent inflation from climbing above 2 percent. Yet the Committee went on to raise rates a total of nine times through December 2018, during which time inflation was always at or below target. In my view, these rate increases were not called for by our symmetric framework.
So why did the FOMC raise rates? I believe that we misread the labor market, thinking we were at maximum employment when, in fact, millions of Americans still wanted to work, and fearing that if we hit maximum employment, inflation might suddenly accelerate, and we would then have to raise rates quickly to contain it. In 2015, FOMC participants estimated that unemployment could not go below 5.1 percent without triggering inflation. Since that time, the unemployment rate has fallen to 3.6 percent; as a result, 2.4 million more Americans have found work, and inflation is still low.
While it was historically a pretty good indicator of labor market tightness, in this recovery, the headline unemployment rate has been giving a faulty signal. Because it counts only people actively looking for work, it ignores people who gave up and left the job market because of the financial crisis. Other measures of the labor market indicate that there may still be slack. The percentage of prime working-age Americans, 25-54, who consider themselves to be in the labor force has nearly recovered to precrisis levels, but is still 2.3 million short of where it was back in 2000.
Policymakers will never have perfect information on the real economy. But raising rates while inflation was low is an example of a shortcoming of how we implemented our framework rather than a shortcoming of the framework itself. We must consider how our existing framework could have performed if we had utilized its full potential to support the economy.
The economy is doing well now, so weren’t the costs of too-tight policy small? There are three potential costs, all of which are important. First, the labor market recovery has been slower than it needed to be. It is hard to know how much slower, but lower interest rates should have led to faster job growth and higher wage growth. Perhaps we’d have achieved maximum employment already if monetary policy had been more accommodative.
Second, by raising rates more quickly than called for by our symmetric framework, we ran the risk of overtightening and causing a recession. Markets signaled this risk with the steep drop in bond yields and equity prices late last year. The FOMC’s quick adjustment to pause further rate hikes was appropriate and, thankfully, seems to have mitigated this risk for now.
Third, inflation expectations today appear to be anchored below our target at around 1.7 percent. While that might seem like a small miss, it means that in the next downturn, we will have less room to respond because real interest rates, net of inflation, ultimately drive economic activity. With a limit to how low nominal rates can go, low inflation expectations directly sap power from our primary policy tool. Once rates hit the effective lower bound again in the future, we will have less power than we planned to have.
My two primary takeaways from this experience are, first, markets have watched the FOMC treat our inflation target as a ceiling, never to be crossed. In my view, we have not implemented our current framework as it was designed to be implemented. For our current framework to be effective and credible, we must walk the walk and actually allow inflation to climb modestly above 2 percent in order to demonstrate that we are serious about symmetry.
Second, as a consequence, it is critical to evaluate any potential new monetary policy framework not only in how it is supposed to work in theory, but also in how it is likely to be implemented in practice when policymakers are facing imperfect information on real economic activity.
In our review, it will be easy to say that we will be more aggressive after the next downturn. Make-up strategies such as price-level targets offer this attractive feature. But we must honestly ask ourselves: If we felt compelled to raise rates when inflation was below target in this recovery, would we really keep rates low when inflation is above target next time? Count me as skeptical.
1 Board of Governors of the Federal Reserve System, Monetary Policy Report, (https://www.federalreserve.gov/monetarypolicy/2019-02-mpr-summary.htm) February 22, 2019, page 38.
2 Jing Cynthia Wu and Fan Dora Xia, “Measuring the Macroeconomic Impact of Monetary Policy at the Zero Lower Bound,” Journal of Money, Credit and Banking, Vol. 48, No. 2-3, 2016, pp. 253-91 and as updated at https://www.frbatlanta.org/cqer/research/shadow_rate.aspx and Haver Analytics.