This article is written by former New York Fed President Bill Dudley.
Next year, the Federal Reserve will conduct a globally impactful activity—a regular monetary policy framework review, during which it will reconsider how to manage the world's largest economy.
Although the Federal Reserve plans to focus on some of the right issues, some important aspects seem to be overlooked.
The positive side is that the Federal Reserve seems ready to abandon a system designed to prevent short-term interest rates from staying at the zero lower bound for a long time. This system was introduced after a review in 2020, against the backdrop of the 2008 financial crisis and the zero interest rate experience during the global pandemic. The system stipulates that the Federal Reserve must meet three conditions to maintain interest rates at the zero lower bound: employment must reach its highest level consistent with stable inflation; inflation must reach 2%; and expected inflation must exceed 2% to offset past inflation shortfalls. This was meant to more firmly anchor inflation expectations at 2%, preventing unexpected policy tightening if these expectations were to decline.
This strategy looks to address past crises, but it turns out to be unsuitable for an economy emerging from a pandemic. By March 2022, the Federal Reserve's policy interest rate was still close to zero, and the Federal Reserve was still purchasing U.S. Treasury bonds and mortgage-backed securities to suppress long-term rates—while the unemployment rate was at 3.8% and the Federal Reserve's preferred measure of inflation exceeded 5%. Even with an overheating economy, the Federal Reserve was still providing special stimulus.
Powell seems to be aware of this issue. He noted that the risk of being locked at the zero lower bound may have decreased because the neutral interest rate—one that neither stimulates nor hinders growth—has been above that of the decade following the 2008 crisis. As Powell said: 'You don't need to aim for overshooting; you just need to aim for inflation.'
So far, so good, but there are three important issues that seem to have not been included in the review agenda.
First, the Federal Reserve needs a framework for quantitative easing (and quantitative tightening). Without a framework, market participants find it difficult to understand when and how these policies will be implemented. This undermines their effectiveness, as market expectations affect long-term U.S. Treasury yields, financial conditions, and the transmission of monetary policy to the economy.
Secondly, a system is needed to assess the costs and benefits of quantitative easing measures to better understand which measures are actually worth implementing. For example, in light of the obvious fact that the development of COVID vaccines and the Biden administration's massive fiscal stimulus measures would eliminate the need for additional monetary stimulus, the central bank purchased $1.4 trillion in assets in 2023. These purchases will ultimately cost U.S. taxpayers over $100 billion. The total cost of quantitative easing during the pandemic could reach $500 billion.
Third, the Federal Reserve should change its interest rate target. The federal funds rate is outdated; it tracks a market that banks mostly no longer use due to ample bank reserves. This complicates the central bank's work: for example, in 2015, it introduced overnight reverse repurchase agreements to prevent the federal funds rate from falling below its target range. The Federal Reserve should have switched to using the interest rate on reserves held at the central bank years ago; the Federal Reserve regained this power in 2008. It's never too late to fix the problem.
Some argue that the Federal Reserve cannot easily change its interest rate target because the reserve rate is set by the Federal Reserve Board, not by the Federal Open Market Committee (FOMC), which is responsible for monetary policy. This is unconvincing; the Board can vote once a year to comply with FOMC recommendations on what the reserve rate should be. Given the high degree of overlap in membership between these two entities, the risk of conflict seems negligible.
Another question worth considering is whether the Federal Reserve should raise its inflation target above 2% to reduce the risk of hitting the zero lower bound. As Powell pointed out, this risk has already diminished. More importantly, even if inflation surges, the 2% target helps keep inflation expectations well anchored. Changing the inflation target could undermine confidence in the Federal Reserve's resolve—at a time when inflation is still above the Federal Reserve's target, and the Federal Reserve may face pressure to ease monetary policy to help address the unsustainable accumulation of government debt, this is a dangerous move.
As the event of Trump defeating Harris highlights, voters really dislike inflation, and public opinion must be reflected.
Article reprinted from: Jin Shi Data