MNI: Ex-Officials Fear Fed Review Could Be Too Narrow

The Federal Reserve’s framework review is likely to restore greater symmetry between its employment and inflation objectives, but may still end up being too narrowly focused on changes in terminology to be a truly useful exercise in determining what went wrong in the 2021-2022 inflation surge, former Fed officials told MNI. 

“The idea of a skinny revision is a little disheartening. What they went through with the inflation surge of 2021, 2022 and 2023 is a huge blunder. I’m sure they recognize they made mistakes, and not just in hindsight,” said Jeffrey Lacker, former Richmond Fed President.  “The last framework revision clearly contributed to that. It tilted things toward the full employment mandate.” 

The central bank’s framework was first explicitly established in 2012, but was the culmination of a long-standing effort at developing a constitutional document to guide policy that began in the mid-1990s, ex-officials said.  

The problem with the 2020 review, according to critics, is that the changes made to the framework were addressing a very specific set of circumstances – in particular, a chronic if modest undershooting of the Fed’s 2% target.

SHORTFALLS AND OVERSHOOTS 

The 2020 changes included a shift from targeting “deviations” from full employment to targeting “shortfalls,” and expanded the definition of full employment to be “broad and inclusive.” At the same time, officials committed to a new flexible average inflation target program without a specific timeframe over which the target was expected to be reached. In addition, policymakers promised to overshoot 2% for some time “following periods when inflation has been running persistently below” target.  

All of these factors, in addition to forward guidance that tied the prospect of Fed hikes to a tapering of its balance sheet, are seen as having hamstrung Fed action, thus delaying rate increases and forcing them to occur more aggressively and arguably to a higher level than might otherwise have been needed. 

Former New York Fed President Bill Dudley also has modest expectations for the scope of the current review. 

“I think it will be relatively narrow – moving back towards the 2012 framework on employment and inflation and keeping 2% inflation as the target – always without offsetting undershoots with overshoots. I do not expect a QE/QT cost-benefit framework but believe it is needed,” he said. 

Andrew Levin, a former Fed board staffer and special adviser on communications, thinks the Fed’s inflation blunder was sufficiently egregious to warrant a wide-ranging external review like the one ex-Fed chair Ben Bernanke conducted for the Bank of England. 

“The Fed should welcome an external review that would provide a more comprehensive ‘lessons-learned’ from the past five years. Such an initiative could be roughly similar to Bernanke’s recent review of forecasting and communications at the Bank of England.”

Dudley agreed: “I am hopeful that Powell will pursue a Bernanke-type of proposal --staff forecast with scenarios.” (See MNI: Fed To Examine If Framework Robust To Any Scenario) Dudley recently chaired a G30 study regarding the framework which argued that calls for greater clarity from policymakers on how to achieve their objectives. 

TIME INCONSISTENCY

However, Levin is sympathetic to the idea that this particular five-year review is not especially well-timed, and thus might need to be more circumscribed. 

“Chair Powell should be applauded for revising the policy framework that will be passed on to his successor. Nevertheless, the next Fed chair might well decide to change course and follow a different approach,” he said. (See MNI POLICY: Warsh Could Reshape Fed On Rates, Communication)

“The framework adjustments that the Fed made in 2020 mostly turned out to be irrelevant or counterproductive. Thus, the simplest approach right now would be to revert back to the previous framework that the Fed adopted in 2012.”

Former Philadelphia Fed President Charles Plosser pointed to his own recent recommendation to the Shadow Open Market Committee that the framework revision include a “more thoughtful and thorough review of the inflation process and dynamics and how they relate to monetary policy tools.”