Strategy Reviews

These are introductory remarks for the panel discussion on “The Next Strategy Reviews,” for the Hoover Conference, “Getting Global Monetary Policy On Track.” The panelists were Athanasios Orphanides, Mickey Levy and Charles Plosser, Jón Steinsson, and Lawrence Summers. Slides are available at the link, and video and text will be up soon. Summers’ slides are good, but he gave a rousing on the spot strategy suggestion worth finding when it’s up. (I’ll blog it.) The whole conference was excellent, and I’ll give some reviews later.

The Next Strategy Reviews: Introduction

The US Federal Reserve and the European Central Bank are beginning formal reviews of their policy strategies. Other central banks are asking themselves the same questions.

We have assembled here a panel with superb academic and practical experience in monetary policy, but none of whom currently serve in central banks. I think it’s about the best set of outside-the-bubble consultants a central bank could ask for in a policy strategy review!

I like the word “strategy” that the Fed and ECB have adopted in this effort. John Taylor frequently reminds people that his “rule” is not meant as a recommendation that central banks mechanically follow a formula, but rather that rules anchor a strategy. Central banks consider the rule and think in terms of it, but also understand and explain deviations from a rule in response to other events. The stable strategy, not a mechanical rule, anchors expectations.

After an extensive extended and collective deliberation, the Fed adopted a new strategy framework known as Flexible Average Inflation Targeting. This framework was explicitly designed by a worldview that “the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past,”  and a consequent judgement that “downward risks to employment and inflation have increased.” A shift to “inclusive” employment, a return to the old idea that economic “shortfalls” can be filled, and a promise not to preempt future inflation but rather let inflation run hot above 2% to make up past shortfalls followed. These promise of future dovishness were hoped to stimulate demand in the short run.

In short, the Fed adopted an elaborately-constructed new-Keynesian forward-guidance defense against the perceived danger of deflation and stagnation at the zero bound.

No sooner was the ink dry on this grand effort, however, than inflation shot up to 8%, and the zero bound seemed like a quaint worry. Something clearly went drastically wrong. Naturally, the first question for a strategy review is, how can we avoid having that happen again?

Inflation eased without interest rates substantially higher than inflation or a large recession. I think I have a (and the only) clear and simple explanation for that, but I promised not to digress into a fiscal theory today. Still inflation is persistently high, raising the obvious worry that it’s 1978 again. Obviously, central banks have a range of worries on which to focus a new strategy, not just a return to a long-lasting zero bound. (Though that could happen too.)

I’m the moderator here, so I’ll take as my job to pose the questions which I hope this review will answer, and invite the panelists to supply answers.  (I wrote previously on strategy review at the  2020 St. Louis Fed Homer Jones Lecture, and most of those thoughts still apply.)

React or guide? It seems clear to me that policy will have to be described more in terms of how the Fed will react to events, rather than in standard forward guidance terms, unconditional promises of how the funds rate will evolve. It will involve more “data-dependent” rather than “time-dependent” policy.

In part, that must come, I think, as a result of the stunning failure of all inflation forecasts, including the Fed’s. Forecasts did not see inflation coming, did not see that it would surge up once it started, and basically always saw a swift AR(1) response from whatever it was at any moment back to 2%. Either the strategy review needs to dramatically improve forecasts, or the strategy needs to abandon dependence on forecasts to prescribe a future policy path, and thus just state how policy will react to events and very short-term forecasts. I state that as a question for debate, however.

Guidance and QE? Is forward guidance as a separate policy tool worth keeping, and if so how? I think not, because I think the theoretical basis for powerful forward guidance is wrong (see here). I also think QE is basically powerless except as a signal.  But these additional “tools” were central parts of the zero bound efforts, so how much should they be retained in the new strategy is a central question.

Price level? FAIT prescribes a period of above-target inflation following a period of unintended below-target inflation. In so doing it moves towards a price-level target. Much of the intuition for the wisdom of that decision seems to apply in the other direction too: expectations of further inflation would be tamed if people thought the Fed would move past disinflation to a period of below-target inflation. The Fed does not, in practice, seem inclined to move below 2% in reaction to the large positive error, but perhaps it should. To what extent should the new strategy include such a move to a price level target, and should it be symmetric?

Rules or outcomes? How much should a rule for the Fed’s actions be part of the strategy? Should it include numerical guideposts? The FAIT was criticized for being too flexible, that practically anything could be rationalized. Should the Fed hold itself more tightly to a quantiative benchmark? One can also argue that discretion in methods but commitment to outcome is just as effective for guiding expectations. Mario Draghi said “whatever it takes,” and markets believed him, though he did not say a word about just what he might do.

Contingency plans? Stress tests? How detailed should the Fed’s internal (I hope a lot more) and public contingency planning be? As Jón Steinsson remarked later, we all thought the FAIT included an implicit break glass in case of emergency plan, “but if inflation surges we’ll raise rates quickly.” Apparently not. Having that plan would have been useful. But as Amir Yaron’s presentation about October 7 emphasizes, a central bank cannot lay out contingency plans for everything. Still, the Fed currently lays out a forecast, then plans as if that’s certain. A few contingencies seem worth stating. Shouldn’t the Fed stress test its monetary policy?

More shocks? Surely a central lesson of 2021 is the there are inflationary (and maybe deflationary) shocks out there, inflation is not just the result of interest-rate-setting mistakes. The Fed seems to think “supply shocks” drove inflation massively above the 2% target. OK, shouldn’t the “strategy” then include a massive effort to measure, diagnose, and respond quickly to “supply” shocks? If TVs couldn’t get through ports, and that caused 8% inflation, where is the team watching how many TVs can get through ports? “Supply shocks” are economics, not a dog-ate-my-homework excuse for inflation. Perhaps a sharp shift in relative demand for goods over services provoked inflation. OK, but how does that catch the Fed and its forecasters completely by surprise? That shouldn’t be hard to see and react to appropriately. I, of course, think a massive fiscal shock drove inflation and its miraculous easing. And the Fed studiously pays little attention to the inflationary possibilities of fiscal shocks.

(An alternative theory is that the Fed diagnosed covid as a demand shock needing “stimulus.” It agreed with the rest of the government’s $5 trillion spending, much of it raw fiscal stimulus, and helped by monetizing $3 trillion of that. It further helped by deliberately keeping interest rates low, so the fiscal shock would work. Even inflation is regarded by some as a desirable intentional Lucas-Stokey state-contingent default to finance the needed fiscal stimulus. If so, however, the current focus on transparency might suggest the Fed admit it, and even defend it proudly.)

What will the Fed do with a geopolitical shock, or a global sovereign debt shock? These will happen too. How will it respond to stagflation, not perceived stagZLB?

Should monetary policy respond in the same way to output and inflation, no matter the source of the shock? Or should the Fed get better at understanding shocks, which are currently really just error terms in equations, things we don’t know? And then respond differently to different shocks? Surely the Fed should not respond to “supply” driven output declines the same way it responds to “demand” driven output declines. Now that the Fed admits “supply” shocks exist, an effort to respond appropriately seems right. But maybe not. Maybe a good strategy is simple, and just says react to inflation no matter what its source.

Limits. The environment has changed, posing new limitations on monetary policy. How will the strategy think about these limits?

Fiscal limitations loom. Debt to GDP was 25% in 1980, and still constrained monetary policy. It’s 100% now, and only not 115% because we inflated away a bunch of it.  Each percentage point of real interest rate rise is now quickly (thanks to the Treasury’s decision to issue short, and the Fed’s QE which shortened even that maturity structure)  a percentage point extra interest cost on the debt, requiring a percent of GDP more primary surplus (taxes less spending). If that fiscal response is not forthcoming, higher interest rates just raise debt even more, and will have a hard time lowering inflation. In Europe, the problem is more acute, as higher interest costs could cause sovereign defaults. Many central banks have been told to hold down interest rates to make debt more sustainable. Those days can return.

Financial limitations loom as well. Many banks and other financial institutions will lose a lot of money if interest rates rise. SVB and the UK’s pension fiasco described by Carolyn Wilkins are early warnings. I see that as a version of a fiscal limit, because higher rates then provoke bailouts. Shouldn’t the strategy mix regulation and monetary policy a little better so that higher interest rates do not threaten financial trouble?

Ignorance. Finally, we should admit that neither we, nor central banks, really understand how the economy works and how monetary policy affects the economy. There is a complex verbal doctrine that bounces around central banks, policy institutions, and private analysts, asserting that interest rates have a relatively mechanical, reliable, and understood effect on “spending” through a “transmission mechanism” that though operating through “long and variable lags” gives the Fed essentially complete control over inflation in a few years. The one thing I know from 40 years of study, and all of you know as well, is that there is no respectable well-tested economic model that produces anything like that verbal doctrine. (More here.)  Knowing what you don’t know, and that nobody else does either, is knowledge. Our empirical knowledge is also skimpy, and the historical episodes underlying that experience come with quite different fiscal and financial-structure preconditions. 1980 was a different world in many ways, and also combined fiscal and microeconomic reform with high interest rates.

So, what strategy do you adopt when you are really not sure how the levers are connected to the wheels?

John Taylor has long preached the Taylor rule not because it is exactly optimal in a given model, but because it does a pretty good job in a wide variety of models. We want that sort of robustness in a strategy, even to models we haven’t written yet, or to the possibility that the standard doctrine is also wrong.

I’ve asked a lot of questions. It’s time for you to offer answers!

(Larry Summers’ provocative and thoughtful answer is basically, “don’t try.” Give up on the whole strategy and communication business. Given how hard an answer to all my questions is, it’s an intriguing view.)