On Thursday, January 14, 2021, Federal Reserve Chair Jerome Powell joined Markus Brunnermeier for an online conversation. The following topics were discussed: (1) the new flexible average inflation targeting framework, (2) the possibility of an “inflation whipsaw,” (3) the importance of central bank independence to avoid fiscal dominance and of macroprudential regulation to avoid financial dominance, (4) the difference between the COVID crisis and Great Recession, and (5) various crisis response measures the Federal Reserve employed during the COVID crisis.
Watch the full presentation below. You can also watch the Markus’ Academy webinars on the Markus’ Academy YouTube Channel.
Flexible inflation targeting was successful, but needed to be adapted to the new normal of policy rates near the lower bound. Over the course of 2019-2020, the Fed engaged in a review of its strategy for achieving its dual mandate goals of maximum employment and price stability. In August, the Fed announced the results of this review, which involved significant changes to its strategy for achieving both of these goals.
Regarding the inflation goal, the Fed reaffirmed its understanding of price stability as achieving 2 percent annual inflation over time. To meet this goal, the Fed instituted a flexible average inflation targeting regime. Following periods when inflation has run persistently below 2 percent, they will likely aim to achieve inflation moderately above 2 percent for some time. Flexible means that Fed policy won’t be tied to a formula. Monetary policy will continue to reflect a broad array of considerations and judgment, and will include elements of risk management.
Regarding the maximum employment goal, the Fed added new language saying that maximum employment is a broad and inclusive goal, which reflects the Fed’s appreciation of the benefits of a strong labor market for many in low- and moderate-income communities and the overall economy. The Fed also said that it will react only to shortfalls from maximum employment, as opposed to deviations from maximum employment. That reflects its view that employment can run at or above real-time estimates of its maximum without causing concern, unless accompanied by signs of an unwanted increase in inflation or other risks.
Surveys show that market participants do not expect the Fed to raise rates until inflation has reached 2 percent and until the labor market is very strong. That is consistent with the new guidance. But The Fed understands that the public will need to see policymakers allow inflation to move moderately above 2 percent for a time before the new framework will be seen as fully credible.
As the pandemic recedes, the Fed sees the potential for increased spending as people return to their normal lives. That could generate some upward pressure on prices. But a modest one-time increase in prices is very unlikely to generate persistently high inflation. The U.S. economy is a long way from maximum employment, the Phillips curve is flat, and inflation persistence is low.
A key difference between macro-prudential regulation in the US and many other countries is that the Fed relies on strong through-the-cycle tools rather than time varying-tools. Timing of macro-prudential policy moves can be difficult to get right. The Fed’s tools are always on, in good times and bad. For example, the Fed runs very strong stress tests that require banks to be resilient against the kinds of massive stresses that can suddenly appear in a crisis.
The COVID shock and the GFC shock were fundamentally different. The GFC resulted from the build-up of unsustainable imbalances in the economy, such as the housing bubble that popped and the undercapitalized banking system that amplified rather than absorbed that shock. In addition, households entered that crisis with unsustainable debt levels. The pandemic is effectively a natural disaster that struck a well-performing economy. This time the banking system was much better capitalized and household finances were in relatively good shape. Fiscal and monetary policy responded quickly, powerfully, and in a sustained manner to COVID. Still, the single most important economic policy is actually healthcare.
Treasury market functioning is central to the entire financial system, and bestows a vast good to the public. The Fed’s actions to facilitate Treasury market functioning are tied directly to its mandates on maximum employment, price stability, and financial stability. The Fed is looking at the role of regulation and market structure to improve how this market works.
The Fed and Treasury worked together closely to stand up several emergency lending facilities. In some cases, such as the facilities for corporate and municipal bonds, the announcements of the facilities led to significant healing in private markets. So, ironically, low take-up in these facilities was a sign of success. On the other hand, it has proven harder to reach small and medium-sized businesses.
Central bank independence is an institutional arrangement that has served the public well. Every democratic advanced economy around the world has an independent central bank, though institutional arrangements differ. Such independence is particularly useful in times of crisis, but also through the business cycle.
Public debt level is at record high and is growing substantially faster than the economy. However, the economy is a long way from fiscal dominance, and may never get there. It is certainly not a factor the Fed considers in any way.
Now is not the time to talk about exit from the path of asset purchases. The economy is far from the Fed’s The Fed is strongly committed to its framework and to using its monetary policy tools until the job is well and truly done. When the FOMC has clear evidence that the economy is on track to make substantial further progress toward its goals, they will communicate very clearly to the public, well in advance of active consideration of beginning a gradual taper of asset purchases.
The Fed is committed to studying benefits, potential costs, and unresolved questions around a CBDC. The Fed is investing heavily in understanding the technology and analyzing the policy questions. As it goes through this process, it will conduct a great deal of outreach to interested constituencies, including elected representatives, financial-sector participants, and others. The time it will take to this properly—which is more important than doing it first—is measured in years rather than months.
It is an extraordinary time to be doing economic research. In the near term, a high research priority is understanding what happened during the acute phase of the crisis and evaluating the policy responses. Longer term, we want to understand the extent of labor market scarring and damage to productive capacity. We are at early stages of examining the implications of climate change for the financial sector and economy.
On a positive note, we should be optimistic about the economy for the next couple of years. The country needs to get through this very difficult winter, with the spread of COVID. But as the vaccines go out and we get the virus under control, there is a lot of reason to be optimistic about the U.S. economy.