The Federal Reserve’s five-year review of its monetary policy framework is well underway and should be wrapped up by late summer.
The conduct and operation of monetary policy appropriately involves highly technical issues. But will the framework review perpetuate noise and complexity surrounding the Fed, or could the Fed help lessen it by better tackling key communication challenges?
What is on the docket?
Many nitty gritty issues will legitimately be on the docket for the framework review. Does the Fed’s framework treat undershoots and overshoots from the inflation target symmetrically? Is the Federal Funds rate still the right key instrument for money market operations? How should balance sheet tools be treated? How explicit could forward guidance be? And can the noise around the dot plot be scaled back or should more coverage be concentrated on the dispersion of views?
What won’t be on the agenda, yet perhaps should?
One lesson from past years that is likely to receive inadequate focus is a frank admission that if monetary authorities simply err and respond too slowly to a shock, the brilliance or lack thereof of any framework is somewhat irrelevant. Relatedly, while the existence of a framework may create a sense of comfort and discipline, a Maginot Line framework built to fight the last war may not be appropriate for the future.
And the review will certainly not ask if America needs 12 regional Fed banks, let alone delve into questions about their governance structure.
One key issue that should be on the docket is excessive Fed communication. Transparency is wonderful, but maybe there can be too much of a good thing.
In the run-up to each Federal Open Market Committee meeting, practically every regional Fed president and many board members give Fed-speak remarks about the state of labour markets and inflation dynamics, offering a recondite glimpse into their thinking about the balance of risks and course for monetary policy. After the FOMC meeting, Chair Jerome Powell holds his highly covered press conference. Financial market journalists cover each speech and press utterance, and markets seemingly hinge on every word and react accordingly. Whether as intended or not is another question.
The heavy Fed focus, whether perpetuated by the media or excess Fed communications, can create the impression that central banks are – to use the title of Mohamed El-Erian’s book – ‘the only game in town’.
Perceptions aside, the Fed is not the only game by a long shot. One of the Fed’s key jobs is to keep inflation low. But inflation largely reflects forces well beyond the Fed’s control. The Fed is hardly responsible for fiscal and structural policies; it is not responsible alone for policies related to financial stability. Tariffs can be highly inflationary. So could mass deportations that alter labour market dynamics. Many argue the Biden administration’s tax cuts pushed aggregate demand well above supply, generating significant inflationary impulses. Global supply shocks, weather and financial crises abroad affect domestic price stability as well. Simply put, the Fed alone cannot determine inflation outcomes.
Further, the Fed’s operational tools for achieving price stability are modest. The key tool at present is the Fed Funds rate. But that is a short-term rate and the Fed has limited capacity to determine longer-term rates, which are key for investment decisions.
Does it matter?
The Fed is often perceived as in control of macroeconomic outcomes, which is hardly the case. With higher interest rates, a soaring interest bill and possible stagflation, a highly visible Fed at the centre of the public limelight runs a greater risk that Congress may blame the Fed, shirk its responsibilities for sound fiscal management (as it long has done and is currently woefully doing) and seek to curb the Fed’s independence in the face of looming fiscal dominance.
Politicians, market participants and individuals may further pressure the Fed to deliver a ‘put’ against stock market declines, market volatility and a major uptick in longer rates.
Highly technical questions are indeed relevant for the review and merit full consideration. But the FOMC should step back and reflect on its communications. This is not a question of dot plots and forward guidance. Rather, fewer FOMC speeches and less visibility may decrease noise and reduce the media and public spotlight on the Fed, opening the door for a greater focus on other aspects of economic decision-making.
The Fed is not the only game in town.
Mark Sobel is US Chair at OMFIF.
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