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Transcript

Tim Sablik: My guest today is Alex Wolman, vice president for monetary and macroeconomic research at the Richmond Fed. Alex, welcome back to the show.

Alexander Wolman: Thanks, Tim. It's good to be back.

Sablik: Today, we're going to talk about the recent revisions to the Fed's Statement on Longer-Run Goals and Monetary Policy Strategy, often referred to as the Fed's monetary policy framework.

In early June, I spoke with Grey Gordon and Felipe Schwartzman about the history and evolution of the Fed's framework. Listeners who are interested in that background should go back and check out that conversation.

As a quick refresher, the Fed unveiled the first version of its framework in 2012, made some small changes over the next several years, and then revised it more substantially in 2020. The Fed has committed to reviewing the framework every five years, and that process culminated in the latest revision that was unveiled in August.

Before we get into what changed, let's talk about what stayed the same. In his speech revealing the new framework, Fed Chair Jerome Powell said, "There is a great deal of continuity with past statements." What has remained consistent since the Fed first revealed its framework in 2012?

Wolman: The Fed's overarching goals are assigned by Congress — the dual mandate of maximum employment and price stability. Those goals naturally remain the centerpiece of the framework.

Price stability continues to be interpreted as a 2 percent inflation target and the FOMC [Federal Open Market Committee] accepts responsibility for inflation, stating that the inflation rate over the long run is primarily determined by monetary policy. Unlike inflation, the level of employment over the long run is not primarily determined by monetary policy, so the Statement on Longer-Run Goals continues to refrain from setting a specific numeric goal for employment.

Sablik: Let's turn to what changed in the latest revision. One major difference is the removal of flexible average inflation targeting, which was introduced in the 2020 revision. What was the rationale for introducing that language in 2020?

Wolman: In 2020, a low natural real rate of interest was both a medium-term and a short-term concern. Because the natural real rate of interest was low, or perceived to be low, the zero lower bound on nominal interest rates might interfere with the Fed achieving its goals. The concern was that if the natural real rate was low, then the nominal interest rate consistent with 2 percent inflation might be so low that the economy would have nominal interest rates close to zero, which, in turn, could lead to inflation persistently below target.

That was an immediate concern in 2020 when the Fed took rates near zero during the pandemic. But it was also a longer-term concern in the wake of the post-financial-crisis experience of several years of near-zero interest rates. Flexible average inflation targeting, introduced in the 2020 version of the framework, was aimed at mitigating the zero-lower-bound-related risk of inflation running persistently below target.

Sablik: As you mentioned, the 2020 revision was informed by the Fed's experiences during the Great Recession and the recovery period of the 2010s. How was the 2025 revision shaped by the COVID-19 pandemic and recovery?

Wolman: Well, as I expect our listeners know, the inflation rate was well above the Fed's target in 2021 and 2022. While it came down sharply in 2023, it remains even now somewhat above target.

In this context, it didn't make sense for the FOMC to emphasize an approach to monetary policy that was tailored to situations where inflation was likely to be below target. At the same time, it was less appealing to adopt an approach aimed at any particular situation — for example, replacing the flexible inflation targeting language with something aimed specifically at situations where high inflation was the prevailing concern. They had taken that approach of going somewhat narrowly after the prevailing conditions in 2020.

Sablik: What approach to inflation did the Fed ultimately outline in the new 2025 framework?

Wolman: The current framework, which I'll refer to as flexible inflation targeting, is essentially a return to form, very similar to what was in the 2012 framework. Implicitly, the framework recognizes that there will be times when monetary policy is chiefly concerned with addressing incipient high inflation, and other times when it is chiefly concerned with addressing incipient low inflation. In either case, the Fed aims at keeping inflation close to its 2 percent target.

One change relative to the pre-2020 framework is that there's a greater emphasis on inflation expectations. I'm quoting here: "The Committee is prepared to act forcefully to ensure that longer-term inflation expectations remain well anchored." I see this as acknowledging that shocks will occur which temporarily move inflation away from target, but policy will aim to keep expected inflation from moving materially away from target.

Sablik: Turning to the other side of the Fed's mandate, did the FOMC adopt any changes to how it describes the employment side?

Wolman: Yeah, there were a couple of changes.

First, the FOMC removed the reference to shortfalls that was added in 2020. As background, prior to 2020, the framework stated that the committee seeks to mitigate deviations of employment from the committee's assessment of its maximum level. In 2020, they changed the word "deviations" to "shortfalls." To me, this was an acknowledgement of the fact that they would not seek to reduce the level of employment unless there were an inflation-related reason to do so. However, Chair Powell noted in an August speech that this language in the 2020 statement caused some confusion, with many interpreting it as saying that the Fed would not move preemptively to check inflation in the event of labor market tightness.

In the new 2025 framework, neither the word "deviations" nor "shortfalls" appears. However, the new framework does note that "employment may at times run above real time assessments of maximum employment without necessarily creating risks to price stability." My interpretation is that the Fed is saying that it won't always preemptively raise rates when employment is above real-time assessments of its maximum level, but it reserves the right to do so.

Another change to the language around employment is that the 2020 framework defined maximum employment as a broad-based and inclusive goal. The 2025 revision says that, "Durably achieving maximum employment fosters broad-based economic opportunities and benefits for all Americans." But it defines maximum employment as, "the highest level of employment that can be achieved on a sustained basis in the context of price stability." This makes it clear that one can't fully separate the two parts of the Fed's mandate.

Sablik: So, to sum everything up, what would you say are the important lessons from the last five years that the Fed has incorporated into the new framework?

Wolman: I'll take the opportunity to reiterate the greater emphasis in the new framework on anchoring inflation expectations at 2 percent. Keeping expectations well anchored helps the Fed be more effective. It was part of the reason why the Fed was able to bring inflation down after COVID without triggering an economic contraction, versus the 1980s when expectations were unanchored. The framework is one tool that the Fed has to help anchor the public's inflation expectations by communicating its commitment to the 2 percent target. Of course, that 2 percent target has not changed since the framework was introduced in 2012.

Sablik: Alex, thank you so much for joining me today to explain the changes to the Fed's framework.