Framework Review

Please consider Powell’s speech on Monetary Policy and the Fed’s Framework Review

At the time of the last review [5 years ago], we were living in a new normal, characterized by the proximity of interest rates to the effective lower bound (ELB), along with low growth, low inflation, and a very flat Phillips curve—meaning that inflation was not very responsive to slack in the economy.

Drawing on an extensive literature on strategies to mitigate risks associated with the ELB, we adopted flexible average inflation targeting—a “makeup” strategy to ensure that inflation expectations would remain well anchored even with the ELB constraint. In particular, we said that, following periods when inflation had been running persistently below 2 percent, appropriate monetary policy would likely aim to achieve inflation moderately above 2 percent for some time.

Rather than low inflation and the ELB, the post-pandemic reopening brought the highest inflation in 40 years to economies around the world. Like most other central banks and private-sector analysts, through year-end 2021 we thought that inflation would subside fairly quickly without a sharp tightening in our policy stance. When it became clear that this was not the case, we responded forcefully, raising our policy rate by 5.25 percentage points over 16 months. That action, combined with the unwinding of pandemic supply disruptions, contributed to inflation moving much closer to our target without the painful rise in unemployment that has accompanied previous efforts to counter high inflation.

Elements of the Revised Consensus Statement

This year’s review considered how economic conditions have evolved over the past five years. During this period, we saw that the inflation situation can change rapidly in the face of large shocks. In addition, interest rates are now substantially higher than was the case during the era between the GFC and the pandemic. With inflation above target, our policy rate is restrictive—modestly so, in my view. We cannot say for certain where rates will settle out over the longer run, but their neutral level may now be higher than during the 2010s, reflecting changes in productivity, demographics, fiscal policy, and other factors that affect the balance between saving and investment.

First, we removed language indicating that the ELB was a defining feature of the economic landscape. Instead, we noted that our “monetary policy strategy is designed to promote maximum employment and stable prices across a broad range of economic conditions.” The difficulty of operating near the ELB remains a potential concern, but it is not our primary focus. The revised statement reiterates that the Committee is prepared to use its full range of tools to achieve its maximum-employment and price-stability goals, particularly if the federal funds rate is constrained by the ELB.

Second, we returned to a framework of flexible inflation targeting and eliminated the “makeup” strategy. As it turned out, the idea of an intentional, moderate inflation overshoot had proved irrelevant. There was nothing intentional or moderate about the inflation that arrived a few months after we announced our 2020 changes to the consensus statement, as I acknowledged publicly in 2021.

Third, our 2020 statement said that we would mitigate “shortfalls,” rather than “deviations,” from maximum employment.

We still have that view, but our use of the term “shortfalls” was not always interpreted as intended, raising communications challenges. In particular, the use of “shortfalls” was not intended as a commitment to permanently forswear preemption or to ignore labor market tightness. Accordingly, we removed “shortfalls” from our statement. Instead, the revised document now states more precisely that “the Committee recognizes that employment may at times run above real-time assessments of maximum employment without necessarily creating risks to price stability.” Of course, preemptive action would likely be warranted if tightness in the labor market or other factors pose risks to price stability.

The revised statement also notes that maximum employment is “the highest level of employment that can be achieved on a sustained basis in a context of price stability.” This focus on promoting a strong labor market underscores the principle that “durably achieving maximum employment fosters broad-based economic opportunities and benefits for all Americans.” The feedback we received at Fed Listens events reinforced the value of a strong labor market for American households, employers, and communities.

Fourth, consistent with the removal of “shortfalls,” we made changes to clarify our approach in periods when our employment and inflation objectives are not complementary. In those circumstances, we will follow a balanced approach in promoting them. The revised statement now more closely aligns with the original 2012 language. We take into account the extent of departures from our goals and the potentially different time horizons over which each is projected to return to a level consistent with our dual mandate. These principles guide our policy decisions today, as they did over the 2022–24 period, when the departure from our 2 percent inflation target was the overriding concern.

We continue to believe that setting a numerical goal for employment is unwise, because the maximum level of employment is not directly measurable and changes over time for reasons unrelated to monetary policy.

We also continue to view a longer-run inflation rate of 2 percent as most consistent with our dual-mandate goals. We believe that our commitment to this target is a key factor helping keep longer-term inflation expectations well anchored. Experience has shown that 2 percent inflation is low enough to ensure that inflation is not a concern in household and business decision-making while also providing a central bank with some policy flexibility to provide accommodation during economic downturns.

Powell Five Key Statements

1. Through year-end 2021 we thought that inflation would subside fairly quickly without a sharp tightening in our policy stance. When it became clear that this was not the case, we responded forcefully, raising our policy rate by 5.25 percentage points over 16 months.
2. There was nothing intentional or moderate about the inflation that arrived a few months after we announced our 2020 changes to the consensus statement
3. We cannot say for certain where rates will settle out over the longer run, but their neutral level may now be higher than during the 2010s, reflecting changes in productivity, demographics, fiscal policy, and other factors that affect the balance between saving and investment
4. We continue to believe that setting a numerical goal for employment is unwise, because the maximum level of employment is not directly measurable and changes over time for reasons unrelated to monetary policy.
5. We also continue to view a longer-run inflation rate of 2 percent as most consistent with our dual-mandate goals. We believe that our commitment to this target is a key factor helping keep longer-term inflation expectations well anchored. Experience has shown that 2 percent inflation is low enough to ensure that inflation is not a concern in household and business decision-making while also providing a central bank with some policy flexibility to provide accommodation during economic downturns.

“We Effed Up!”

Points one through three are as close as you will get to “We effed up big time.” And that is exactly what the Fed did.

Trying to make up for lack of past inflation is idiotic, especially when you don’t even know how to measure it.

The Bernanke Fed and the Powell Fed both ignored obvious asset bubbles because neither counts massive increase in home prices, homeowners’ insurance, or property taxes as inflation.

Then the Powell Fed failed to see what massive QE, interest rates near zero percent, a refinancing boom, and three enormous rounds of free money stimulus would do to inflation.

Numerical Targets

Point four is interesting and accurate. “The maximum level of employment is not directly measurable.”

Nor is the “effective lower bound” in interest rates. The ELB is the point at which further rate cuts are counterproductive,

But ELB isn’t zero (or negative where the ECB and Japan set rates).

But in point five, the Fed sticks to its absurd numerical target of 2 percent inflation, with nothing but a belief that 2 percent is correct.

Worse yet, the Fed still measures inflation ignoring housing bubbles.

BIS Deflation Study

The BIS did a historical study and found routine price deflation was not any problem at all.

“Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive,” stated the study.

For a discussion of the BIS study, please see Historical Perspective on CPI Deflations

Concerns about deflation – falling prices of goods and services – are rooted in the view that it is very costly. We test the historical link between output growth and deflation in a sample covering 140 years for up to 38 economies. The evidence suggests that this link is weak and derives largely from the Great Depression.

Deflation may actually boost output. Lower prices increase real incomes and wealth. And they may also make export goods more competitive.

Once we control for persistent asset price deflations and country-specific average changes in growth rates over the sample periods, persistent goods and services (CPI ) deflations do not appear to be linked in a statistically significant way with slower growth even in the interwar period.

Asset Bubble Deflation

It’s asset bubble deflation that is damaging. When asset bubbles burst, debt deflation results.

Central banks’ seriously misguided attempts to defeat routine consumer price deflation is what fuels the destructive build up of unproductive debt and asset bubbles that eventually collapse.

Inflation Expectations Do Not Matter

The Fed’s monetary framework sticks with disproved Phillips Curve and inflation expectation nonsense.

A Fed study and common sense show inflation expectation theory is economic nonsense.

For discussion, please see A Fed Economist Concludes the Widely Believed Inflations Expectations Theory is Nonsense

What little we know about firms’ price-setting behavior suggests that many tend to respond to cost increases only when they actually show up and are visible to their customers, rather than in a preemptive fashion.  

The Fed Chases Its Tail Again

Many years late, the Fed is removing some Bernanke-installed policy nonsense.

Yet, the Fed retains a 2 percent inflation target without knowing how to measure that 2 percent. And it holds on to disproved Phillips Curve and inflation expectation theories.

Thus, the Fed ‘s monetary framework remains seriously flawed.

End the Fed

The one thing worse than having a clueless Fed, is a Fed beholden to the whims of politicians.

Neither Trump nor Powell knows where interest rates should be, but I would rather not have politics be the deciding factor.

We don’t need a new Fed framework or a Trump-appointed Fed puppet. We need to end the Fed.

I Officially Announce my Availability to Become the Next Fed Chair

Before howling, please note my first agenda item.

On July 9, I posted I Officially Announce my Availability to Become the Next Fed Chair

Mish’s 15-Point Fed Plan

1. Explain to the nation why we don’t need a Fed and how independent central banks have created boom-bust cycles of increasing amplitude over time. The main corollary is history shows the one thing worse than independent central banks is a central bank run by politicians, frequently ending in hyperinflation.
2. Surround myself with qualified insiders who understand the Fed but also believe in the mission to end the Fed.
3. Stop paying interest on reserves, phased in over 18 months.
4. Wind down the Fed’s balance sheet totally in 2-3 years.
5. Require that assets available on demand such as checking and savings accounts are truly available on demand. That means demand deposits are parked in overnight US treasuries. This would be phased in over two years. As a result, we would have genuine safekeeping banks.

My 15-point plan is to orderly wind down the Fed, then fire myself.

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