The Federal Reserve Needs a Hard Look in the Mirror

The Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy, published in 2012, established a balanced approach to its dual mandate of price stability and maximum employment. It set a target of 2% inflation but made clear that a numeric employment target is inappropriate because labor-market conditions are determined by factors beyond the scope of monetary policy. Each January, until 2020, the Fed reaffirmed this strategy.

The Fed’s 2020 strategic plan was misguided. It was heavily influenced by fears that the effective lower-bound interest rate was dragging down inflation expectations and that rates could fall to zero, creating challenges for monetary policy. Few within the Fed questioned the presumption that low inflation was harming economic performance and would persist.

This led the Fed to adopt an overly complex and unworkable new scheme of flexible average inflation targeting that favored higher inflation and prioritized an enhanced mandate of maximizing “inclusive” employment. The approach eschewed pre-emptive monetary tightening when higher inflation appeared imminent, which seems at odds with the Fed’s goal of managing inflationary expectations.

The new 2020 framework was a sharp departure from the 2012 statement and the practices with which the Fed had succeeded in the past. Lost was

Paul Volcker

and

Alan Greenspan’s

fundamental theme that price stability is the most important contribution monetary policy can make for sustained economic growth and job creation. The benefits of the Fed’s balanced approach were cast aside for asymmetries and greater reliance on the Fed’s discretion and judgment.

Things began to unravel even quicker than we had anticipated following our early published critique of the plan. As inflation soared, the Fed kept interest rates at zero and continued massive asset purchases, dismissing inflation risks to support employment. Eschewing pre-emptive tightening proved costly as aggregate demand soared and employment rapidly recovered.

Amid its policy missteps of the past two years, the Fed has reaffirmed its 2020 plan. Doing so this coming January would highlight the lack of a viable strategy and reconfirm that the Fed is adrift, further denting its credibility. Instead, the Fed should announce that it is postponing its vote and immediately reassessing its strategy.

The Fed’s review should address the inherent weaknesses of the current strategy and consider the appropriate roles of systematic guidelines and rules that could help avoid major policy mistakes. It is essential to replace the unnecessarily complex framework of flexible average inflation targeting, which lacks any numeric guideposts for how high or long the Fed should tolerate inflation higher than 2% following a period of sub-2% inflation or what it should do following high inflation. Restoring a simple 2% inflation target with numeric tolerance bands, or even a simple average inflation target of 2% that addresses overshoots and shortfalls, would clarify monetary policy and Fed communications.

The strategic review must also assess the Fed’s monetary policy tools. Reinstating pre-emptive monetary tightening is essential to maintaining the Fed’s credibility and keeping inflation expectations anchored at 2%. This would reduce the risk that higher inflation becomes entrenched or self-sustaining. In 2021 and 2022, the Fed seemingly forgot this critically important lesson from the 1970s.

The use of forward guidance as a policy tool in place of actual policy changes also deserves scrutiny. Forward guidance presumes that the Fed has the credibility to manage expectations through words alone, which is dubious. Policy changes speak louder than words. The Fed must also reassess the costs and benefits of its balance-sheet policies. If the balance sheet is deemed an important monetary-policy tool, it should be integrated more closely into the bank’s traditional interest-rate decisions and objectives.

Mission creep continues to create problems for the Fed. While the enhanced mandate of maximum inclusive employment is a laudable goal, the Fed must emphasize that it cannot be quantified and fine-tuning the labor market is beyond the scope of monetary policy.

Finally, the Fed must consider the potential contributions the Taylor Rule and other such systematic rules could play in the conduct and communication of monetary policy. These valuable benchmarks would be more helpful than forward guidance and help avoid major policy mistakes.

If the Fed tackles a review and takes steps to acknowledge and correct the shortcomings of its 2020 strategy, it can strengthen its credibility and improve future monetary policy.

Mr. Levy is senior economist at Berenberg Capital Markets and a visiting scholar at the Hoover Institution. Mr. Plosser is a former president of the Federal Reserve Bank of Philadelphia and a visiting fellow at the Hoover Institution. Both are members of the Shadow Open Market Committee.