Next year, the US Federal Reserve will undertake an exercise with global implications: the periodic monetary policy framework review, at which it rethinks its approach to managing the world’s largest economy.
Although the central bank is planning to focus on some of the right things, it appears that important bits will be left out.
On the positive side, the Fed seems poised to scrap a regime aimed at preventing short-term interest rates from staying stuck at the zero lower bound. Adopted at the 2020 review, following the zero-interest-rate experiences of the 2008 financial crisis and the global pandemic, it committed the Fed to keep rates at the lower bound until three conditions had been met: employment had reached the highest level consistent with stable inflation; inflation had reached 2%; and inflation was expected to climb above 2% to offset past downside misses. This was supposed to keep inflation expectations more strongly anchored at 2%, preventing an unintended tightening of policy if those expectations were to fall.
The strategy was oriented toward fighting the last war, and proved poorly suited for an economy emerging from the pandemic. By March 2022, interest rates were still near zero and the Fed was still buying Treasuries and mortgage-backed securities to push down longer-term rates — while the unemployment rate was 3.8% and the central bank’s preferred measure of inflation exceeded 5%. The Fed was providing extraordinary stimulus even as the economy overheated.
Chair Jerome Powell appears to recognize the problem. He has noted that the risk of getting pinned to the lower bound has likely declined because the neutral interest rate — the rate that neither stimulates nor hinders growth — is higher than it was in the decade following the 2008 crisis. As Powell put it: “You don’t target an overshoot, you just target inflation.”
So far so good. But there are three important issues that don’t appear to be on the review’s agenda.
First, the Fed needs a framework for quantitative easing, the asset purchases it has used to provide added stimulus (and for its reversal, known as quantitative tightening). Without a framework, market participants struggle to understand when and how the policies will be implemented. This undermines their effectiveness, because market expectations affect longer-term Treasury rates, financial conditions and the transmission of monetary policy to the economy.
Second, a regime is needed to assess the costs and benefits of quantitative measures, to better understand what’s actually worth doing. Consider, for example, the last year of the purchase program that ended in March 2022: the Fed purchased $1.4 trillion in asset at a time when it was pretty clear that the development of Covid vaccines and the Biden administration’s immense fiscal stimulus would obviate the need for the added monetary stimulus. Those purchases will end up costing the U.S. taxpayer more than $100 billion. The total cost of the pandemic-era quantitative easing could reach $500 billion.
Third, the Fed should change its interest-rate target. The federal funds rate is obsolete, tracking a market that banks mostly don’t use anymore because bank reserves are so plentiful. This has complicated the central bank’s job: In 2015, for instance, it introduced an overnight reverse repo facility to keep the fed funds rate from falling below its target range. The Fed should have switched to the interest rate on the reserves banks hold at the central bank years ago, a power the Fed got back in 2008. Better late than never.
Some argue that the Fed can’t easily switch targets, because the rate on reserves is set by its Board of Governors, not by the Federal Open Market Committee that’s responsible for monetary policy. This is unconvincing. The Board of Governors could vote once a year to abide by the FOMC’s recommendations on what the interest rate on reserves should be. Given the significant membership overlap between the two entities, the risk of conflict seems negligible.
There’s also one issue that’s not worth considering: Whether the Fed should raise its inflation target above 2%, to reduce the risk of getting stuck at the zero lower bound. As Powell noted, that risk has receded. More important, the 2% target has helped keep inflation expectations well anchored, even when inflation was soaring. Changing the target could weaken confidence in the Fed’s resolve — a dangerous move at a time when inflation is still above the Fed’s objective and the central bank might face pressure to loosen monetary policy to help deal with the government’s unsustainable debt buildup.
As Donald Trump’s victory over Kamala Harris underscored, voters really don’t like inflation. The will of the people has to count for something.
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