When US Federal Reserve Chair Jerome Powell speaks at next week’s annual economic conference in Jackson Hole, Wyoming, people will be listening intently for any hint about what the central bank will do with interest rates at its September policy making meeting.
They’ll probably be disappointed. Still, there are plenty of crucial questions about the future of monetary policy that Fed officials can and should address.
I expect Powell to emphasize the progress the Fed has made toward its dual goals of price stability (which it defines as 2% inflation) and maximum sustainable employment. He’ll likely observe that the two are in closer balance, implying that tight monetary policy is no longer warranted. I would be surprised, though, if he offered any indication of the size of the first interest-rate cut, which is almost certain to come in September. That would unnecessarily front-run the policy-making Federal Open Market Committee, which will have more data — including another jobs report — to consider between now and then.
Fed officials might also reflect on some big themes from the past several years. They should be thankful, for example, that people’s inflation expectations stayed well anchored during the pandemic, even though the Fed was slow off the mark in responding to the surge in actual inflation. Beyond that, they could consider the effect of the Fed’s communications on the economy: The speed with which financial markets respond to the central bank’s pronouncements suggests that monetary policy lags might be shorter and less variable than they were when it was less transparent.
Looking forward, I’m most interested in how Fed might change the way it conducts monetary policy. Here are five questions that come to mind.
Should monetary policy be more preemptive?
The Fed made a mistake during the pandemic by committing to keep short-term rates near zero until the economy was judged at full employment and inflation had climbed above 2% and was expected to stay there for some time. This meant that monetary policy remained very accommodative even when the labor market was very tight and prices were surging. Better to start removing monetary stimulus sooner, with the goal of reaching neutral at the same time the economy reaches full employment and the Fed’s inflation objective. Arriving late means monetary policy must become restrictive, which unnecessarily raises recession risks.
Should the inflation target be higher?
Some want to raise the Fed’s inflation target — say, to 3% from 2% — so the Fed will have more room to cut interest rates before hitting the zero lower bound. This is a bad idea. Changing the target would risk the stability of inflation expectations that proved so important during the pandemic: If the Fed moves the goal posts once, people might reasonably worry that it’ll do so again. Also, the Fed might not need more room. If the neutral interest rate has risen, as generally believed, that leaves more space between where rates will normally be and zero.
Should the Fed change the inflation target to a range?
A range of perhaps 1.5% to 2.5% could be a good idea. It explicitly acknowledges that the Fed can’t control inflation precisely, and it allows the Fed to differentiate between small, unimportant deviations and those that require a monetary policy response.
How and when should the Fed engage in the asset purchases known as quantitative easing?
The Fed has no well-defined framework for evaluating the costs and benefits of quantitative easing. The practice affects the Fed’s earnings and remittances to the Treasury, as evidenced by the $188 billion (and still expanding) hole in the central bank’s balance sheet. Officials should pay more attention to such costs, and consider when they might justify winding down a QE program with diminishing benefits.
Should the Fed stop targeting the federal funds rate?
In setting interest rates, the Fed has long focused on the federal funds market, where US banks lend money to one another. This no longer makes sense. The market has become smaller, increasingly idiosyncratic and the Fed has had to come up with solutions -- notably its overnight reverse repo facility -- to ensure that the federal funds rate doesn’t sink below the bottom end of its target range. Instead, the Fed should just use the interest rate it sets on bank reserves as the benchmark for other money market rates.
If Fed officials don’t take up these questions publicly at Jackson Hole, they’ll certainly get plenty of attention on the sidelines — and in the Fed’s monetary policy framework review, scheduled to be completed in 2025.
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