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• Monetary Mystique and the Fed's Path Toward Increased Transparency
• The Origins of the 2 Percent Inflation Target
• The Fed's New Framework

Transcript

Tim Sablik: My guests today are Grey Gordon and Felipe Schwartzman, both senior economists at the Richmond Fed. Grey and Felipe, thanks for joining me.

Grey Gordon: Thanks for having us.

Felipe Schwartzman: Thanks so much for having us.

Sablik: Our topic for today is the Fed's monetary policy strategy or framework. You're both participating in the Fed's review of its framework, which is going on now. We'll talk a little bit more about that at the end.

To start, I wanted to ask you some questions about the framework itself. Listeners who aren't avid Fed watchers might not be familiar with it. So, what is the framework and how does the Fed use it?

Gordon: The framework is three things together: monetary policy tools, strategies, and communications. For the Fed, the strategy might be flexible inflation targeting. The tools? Well, we know what those are: interest rate setting. And communication? That's all about the FOMC statement, the Teal Book released after five years, and these sorts of things.

Schwartzman: Just building a little bit on what Grey said, [the framework] provides some general guidelines about how the Fed interprets its mandate, what we're trying to do, and what our main tools are in order to do that, without getting into the specifics for each particular circumstance.

Sablik: The Fed formally adopted and revealed this framework in 2012. What were some of the considerations that led to that decision at that time?

Gordon: In the global financial crisis, there was a lot of novel policy experimentation going on and new situations that came up. We had never been to the zero lower bound on interest rates before, and then we hit it. That created a whole host of issues. Research started looking into them, and there were big things popping up theoretically — liquidity traps and all sorts of troubling phenomena. People were also concerned about the secular decline in interest rates. That seemed like it would make hitting the zero lower bound a more frequent occurrence going forward.

Schwartzman: If you look at the framework itself in 2012, that lays out the rationale. They say, "The FOMC is firmly committed to fulfilling its statutory mandate from the Congress of promoting maximum employment, stable prices, and moderate long-term interest rates." So, this is what we're supposed to do.

And then, "The committee seeks to explain its monetary policy decisions to the public as clearly as possible." This is what the framework is. "Such clarity facilitates well-informed decisionmaking by households and businesses, reduces economic and financial uncertainty, increases the effectiveness of monetary policy, and enhances transparency and accountability, which are essential in a democratic society."

So, there's an economic argument. [The framework] makes it easier for us to achieve our goals. Also, from the perspective of the Fed being a public institution that has to respond to society, we have to explain why we do what we do and what it is that we're doing.

Gordon: Yeah, and communication became ever more important because you started experimenting with forward guidance.

Schwartzman: Exactly.

Gordon: So, being able to communicate what you were thinking clearly to the public really moved to the foreground.

Sablik: Digging a little bit further back into the history, what was the Fed's approach to articulating its policy goals prior to the adoption of the framework?

Schwartzman: At first, the Fed did not view communication as an important part of what it did.

There is this very interesting article written in 1986 by Marvin Goodfriend, who was an economist here at the Richmond Fed. Basically what happened was there was a Freedom of Information Act request for Fed materials and the Fed had to go to court and explain why it is that the public could not have access to Fed information. So, the Fed had to go and articulate the reasons why it thought that transparency was not a good thing and that it should be secretive. Marvin Goodfriend critiques those arguments. He says, look, the Fed does not do any good by trying to hide information, and it might be making it harder for it to achieve its goals and do things that it wants to do.

This is certainly not the mainstream view at the time. Greenspan famously was very controlling of information. There's a very interesting Econ Focus article by the Richmond Fed that tells the story of how the Fed got to adopt an inflation target of 2 percent and how that inflation target, at first, was secret. This was something that was only known to the FOMC and it was not known outside.

Bernanke, once he became governor, came from a more academic background where those ideas of transparency were percolating and were much more popular. Between this and all the things that Grey was describing in terms of the financial crisis, it became increasingly more tenable to put out there what it is that the Fed is doing.

There was a context of also increasingly central banks adopting inflation targeting regimes. Bernanke has a book about that where he makes the case that these were really useful, important things to do. So, I think it's all part of this intellectual and policy environment.

Sablik: On that point, the Fed's decision to adopt a formal inflation target was somewhat influenced by the fact that other central banks around the world were doing something similar. Have other central banks adopted monetary policy frameworks similar to the Fed's also?

Gordon: Yeah, many foreign central banks have adopted frameworks similar to the Fed's. But I don't want to claim that they're following us because, like Felipe mentioned, in some cases we were following them.

Most central banks, they're not far from what we're doing, like the flexible average inflation targeting. They all tend to view the interest rate as their primary policy tool. They use that to stabilize inflation. They talk about trade-offs. In particular, a time trade-off comes up pretty often in discussion where they want to return inflation to target over a medium term, but also [want to use] that flexibility to support the economy in the short term.

We don't just use interest rate setting. We also use forward guidance and LSAPs [large-scale asset purchases]. Those other tools are also looked on favorably by foreign central banks. The ECB [European Central Bank], in its 2021 review, said that unconventional policies could make for "potential side effects," for example on the financial sector and inequality. There's also concern with forward guidance, that maybe it could tie your hands in a way you don't want to. That's why communication could be so important. But overall, the frameworks that foreign central banks use are very similar to ours.

Sablik: I think that's a good segue to something I mentioned at the beginning, which is the fact that the Fed's currently reviewing its framework. That's something that it's committed to do every five years. What is the reasoning or rationale behind this periodic review?

Gordon: Many central banks have moved to these regular reviews. I think there's a lot of reasons for this. One thing is doing something at a regular interval divorces you or separates you from responding to current events. It makes you less reactionary.

The second aspect of these regular reviews that's beneficial is it allows you to incorporate advances in research. After there's a big change, we learn a bunch of things about how the economy works, new issues come up. So, doing a regular four- or five-year cycle for reviews lets you look back and think, "OK, what did we learn over the last few years?" Now, if you were to do it every year, you might say, "Well, we didn't learn that much in the last year."

The last thing is the transparency and accountability that we mentioned. Just having [the framework review] be regular means that there's a public aspect to what you're doing. We try to get citizen input into monetary policy to increase that accountability and transparency. So, doing that [review] regularly seems like it should facilitate that.

Schwartzman: If you look at the different frameworks, you can see a little bit of that progression.

The 2012 framework was very much like this is what we're about: 2 percent [inflation target and] we care about unemployment. If we're off, we're going to try to balance that. It's a very short document. It's a one-pager and it mentions financial stability, which was front and center. At the time, the big lesson of the financial crisis is [that] financial stability is a big deal and the Fed has a role to play there.

By the time 2020 rolls out, there are two main concerns that came or things that people perhaps thought they learned. One was that a challenge for monetary policy is when you're very close to the lower bound on what interest rates can be. The Fed cannot pay negative interest rates. It cannot charge banks for holding reserves and people for holding cash. So, this constrains what the Fed can do and there's a question of "What do you do if you cannot use your main policy tool?" The 2020 framework tries to deal with that. They come up with this idea of flexible average inflation targeting.

The other thing that came out is that the recovery from the Great Recession was very slow. Some people took the lesson that shocks can have these very long-term effects on employment and output, and then that the Fed should be extra careful about not interrupting expansions too early. So, there's this language in the framework that talks about employment being an "inclusive" goal. The way many people interpret that is we want to make sure that as many people as possible get included in the labor market. Because once they get included, they have a job and that changes their life. And when people lose their jobs, that has a really long-term impact on their prospects.

Now, we had the pandemic and we had the surge in inflation and all of these things that have happened in the last five years. It seems like it's reasonable again to try to derive lessons from these. This is the work that's being done right now.

Gordon: The move to flexible average inflation targeting, I think, was really geared toward getting inflation that was persistently low up to the 2 percent target. We had been running at 1.6 [percent] for a long time, so we've got to let the economy run hot for a while to get gradually up to around 2 percent where we want to be. It was not looking forward to a massive spike in inflation. That wasn't at the front of people's minds in 2020.

Schwartzman: There hadn't been a massive spike in inflation for decades at that point.

Sablik: Right.

Gordon: If you look at how interest rates evolved over time, by 2012 you could see there was a downward trend in interest rates. But when you get to 2020, we are just in a low-interest-rate world. There were all sorts of theories put forward about why that was. But now interest rates are high again. The issues that they were dealing with in 2012 and 2020 maybe don't look that much like what we're currently dealing with. But they were really big at the time.

Sablik: Yeah, that connects to what Felipe was saying about the zero lower bound and why the Fed would be concerned about that. Hitting that zero lower bound more frequently puts additional constraints on policy that they want to avoid.

Schwartzman: To circle back to your question, "Why do we do the revisions periodically?" There's an element of humility. Understanding macroeconomics is very hard and it's hard, in part, because the world changes. Sometimes it changes slowly, sometimes it changes abruptly. Policymakers are trying to learn from these things, but there's also some catching up that needs to happen.

Sablik: Well, I know I mentioned at the beginning that you're both involved in the current review process. Are you able to share anything with us about what that looks like?

Gordon: Not that much [laughs]. But we can tell you some things.

I think part of the process is internal and part of it is external. There are internal memos being drafted on certain topics. The FOMC reads those memos, they ask questions, and they debate the relative merits of various approaches or solutions. And then part of the process is external. The Fed holds Fed Listens events where citizens can tell policymakers their thoughts and concerns about monetary policy.

Schwartzman: The one thing I wanted to mention is that those memos have involvement from the whole [Federal Reserve] System. Most of the time, the different banks in the system are disconnected from each other. We're talking within the banks, and then our presidents will go and talk to each other. This is by design and it's a good thing because it avoids some groupthink. It's interesting to see how people work in different places and how they think in different places.

At the end of the day, everyone seems to be working in good faith. We are just trying to kind of learn what happened and how to move forward in the best way.

Sablik: Grey and Felipe, thanks so much for joining me today to talk through this. It was really interesting, and I hope we can have you both on again to talk about this once the framework review is finished and unveiled.