Conducting Monetary Policy in an Uncertain Economy
Thank you, Professor Hoshi, for that kind introduction. I would like to express my gratitude to Governor Ueda, the Bank of Japan, and the Institute for Monetary and Economic Studies for inviting me to participate in this important conference. I would also like to thank my fellow panelists for their insights and expertise. The comments I offer today are my own and do not necessarily reflect the views of others in the Federal Reserve System.
The topic for today’s panel is “monetary policy challenges in an uncertain economy.” The global economy has been hit by an unusual number of large shocks in the past 20 years, presenting many challenges for policymakers: the 2008 global financial crisis, the COVID-19 pandemic, the high inflation that followed and now record trade policy uncertainty, to name a few. I will reflect on these four events and then draw lessons from them for policymakers navigating uncertainty.
In each of these episodes, policymakers have faced at least two types of uncertainty: First, uncertainty about the shock itself, and second, implications of the shock for monetary policy. In the 2008 financial crisis, it took almost a year for the magnitude of the crisis to become clear to policymakers, who ultimately realized the U.S. financial system was essentially insolvent. Once the scale of the losses in the banking sector was understood, there was little doubt that massive fiscal and monetary support were necessary.
Similarly, the onset of COVID-19 brought tremendous uncertainty: How contagious was the virus, how deadly, and how quickly would vaccines arrive? Once the seriousness of the pandemic and the implications of shutting down large sectors of the economy became clear, the necessary monetary policy response was also clear: massive support was needed both for the labor market and to keep inflation expectations anchored.
When the economy reopened sooner than expected due to the arrival of effective vaccines, inflation began to accelerate, while the labor market was still indicating significant slack. For example, in the U.S., 12-month core inflation first crossed 2 percent in May 2021 when the unemployment rate was still 6 percent, well above the 3.5 percent level achieved just prior to the onset of the pandemic, a time when inflation was below target. Most forecasters and policymakers, including me, assumed that the increase in inflation would be transitory because there was slack in the labor market and, following years of inflation being at or below target, long-term inflation expectations remained firmly anchored. Thus, it would not require a significant monetary policy response. Indeed, if we had raised rates to fight a mild inflation shock that would have quickly subsided on its own, we would have needlessly harmed the real economy.
Once we saw the magnitude and persistence of the inflation shock and considered the upward price pressure that Russia’s invasion of Ukraine would generate, we realized a strong monetary policy response was necessary in order to preserve anchored inflation expectations and to tamp down any excess demand. We didn’t have the luxury of allowing underlying transitory supply dynamics to play out on their own without a policy response.
The most recent shock, driven by tariffs and trade policy uncertainty, is different from the prior ones. Understanding the shock itself is more straightforward: Officials are engaging in trade negotiations to try to rebalance global trade flows. A large increase in tariffs will increase inflation and decrease economic activity, at least in the short run. But given that monetary policy can either push both inflation and economic activity up or push them both down, tariffs present a special challenge for monetary policymakers. We have to pick one: fight inflation or support economic activity?
At the Federal Reserve there is a healthy debate among policymakers about whether to “look through” the inflationary effects of the new tariffs. The look-through arguments view tariffs as creating a one-time change in the price level—a transitory inflation shock. This view prioritizes support for economic activity by lowering the policy rate while the economy transitions to its new equilibrium, at which point inflation will have returned to a 2 percent rate, albeit at a higher overall price level.
Arguments against looking through tariff-induced inflation focus on the fact that the trade negotiations are unlikely to be resolved quickly. It may take months or years for negotiations to fully conclude, and there could be tit-for-tat tariff increases as trading partners respond to one other. In addition, some tariffs apply to intermediate goods, and it will take time for the full effects of those price increases to pass through to final prices. In the U.S., inflation has also been running well in excess of our 2 percent target for four years. How many years of elevated inflation can occur before long-run inflation expectations lose their anchor? These arguments support a stance of maintaining the policy rate, which is likely only modestly restrictive now, until there is more clarity on the path for tariffs and their impact on prices and economic activity. Personally, I find these arguments more compelling given the paramount importance I place on defending long-run inflation expectations.
Turning to lessons from these episodes: Facing such large shocks and the uncertainties they create, policymakers must use judgment to analyze the shocks and determine the appropriate policy response. Policymakers’ collective judgments are of course imperfect, and when the proper policy response is unclear, moving more slowly can be warranted, even if it means, in hindsight, the response may be viewed as having been somewhat delayed. As my colleague Beth Hammack, president of the Cleveland Fed, recently said, “I would rather be slow and move in the right direction than move quickly in the wrong direction.”
During times of such heightened uncertainty, in the U.S. I often hear suggestions from some observers that policymakers should rely on policy rules, such as the Taylor rule, rather than judgment to guide our decisions. Simple policy rules are appealing for their apparent elegance and because they take imperfect human judgments out of the policy process, but they can lead to absurd recommendations when massive disruptions hit the economy. For example, when COVID-19 hit, the Taylor (1993) rule called for a federal funds rate of -8 percent, ignoring the very real constraint of the effective lower bound. The Taylor rule is silent on what to do when the policy rate hits zero.
Today, while policymakers are debating whether to look through tariff inflation and cut the policy rate or to not look through tariff inflation and hold the policy rate, the Taylor rule, in contrast, will likely call for policymakers to raise the policy rate this year to combat inflation. It makes no distinction whether inflation is caused by excessive demand, disrupted supply or tariffs; all that matters is that inflation climbs faster than unemployment. If that condition is met, rates must go up. Looking through tariff inflation is simply not an option for strict policy rules.
Massive shocks create uncertainty for policymakers, both in understanding the underlying dynamics of the shocks themselves and, for some shocks, in determining the appropriate policy response. In such moments, taking time to get more information to help inform the collective judgments of policymakers may be the best of an imperfect set of options.