Some officials within the Federal Reserve want the central bank to consider a major shift in the way it conducts monetary policy, one that could provide significantly easier money in the case that another recession threatens the U.S.
A least “a few” members of the Federal Reserve system said at the December monetary policy meeting that they were interested in studying alternatives to the Fed’s current regime, minutes from the meeting released Wednesday revealed. The notes don’t identify who the officials were.
The Fed’s current framework is to target inflation at 2 percent. The minutes suggested that officials were particularly interested in the possibility of replacing that target with one of two alternatives.
One would be a price level, rather than a rate of inflation. The other would be gross domestic product, unadjusted for inflation.
The price level could be, for instance, the Consumer Price Index or a similar gauge of the prices of a basket of goods and services. Rather than target the year-to-year inflation rate, the Fed would target a predetermined growing total level of the CPI or equivalent measure.
Either one of those standards would have called on the Fed to pursue a more expansionary monetary policy than it did in the years following the last recession. Following the financial crisis, the Fed took the unprecedented step of lowering its interest rate target all the way to zero and then purchasing trillions of bonds, but nevertheless saw inflation fall below target for most of the next nine years.
A level target would entail more aggressive monetary policy.
The difference between targeting a rate of inflation and a price level is subtle but important. With a rate target, such as today’s 2 percent inflation target, a miss on inflation one year doesn’t necessarily mean a change in policy for the next year. With a level target, however, a miss one year means that the Fed would have to pursue even greater inflation the next year to reach the higher target level.
A level target “would imply that the Fed could be more accommodative and allow some inflation catch-up to make up for past years of undershoots,” three BNP Paribas economists explained in a note on Wednesday’s minutes.
The adoption of a price-level target or a nominal-GDP target would be an even bigger step for the Fed to take than its 2012 decision to formally set a 2 percent inflation target. Then-Chairman Ben Bernanke, supported by then-Vice Chairman Janet Yellen, instituted that target only after years of debate within the Fed.
Similarly, Wednesday’s disclosure that some Fed members are interested in altering the framework is just one step in the early stages of a possible change at the Fed.
In recent months, a few members of the Fed system — Federal Reserve Bank of Chicago President Charles Evans and San Francisco Fed President John Williams — have called for exploring the possibility of price-level targeting.
In October, Bernanke, too, outlined interest in shifting temporarily to price-level targeting during a recession in a post on his blog hosted by the Brookings Institution.
Central bankers are interested in the topic now, as the economy is improving and the Fed is moving toward more historically normal interest rates, because they are beginning to think of ways to better manage the next downturn.
“I think these discussions are likely to intensify, because under the current framework it's not obvious how the Fed could respond effectively to the next recession,” said Roberto Perli, a researcher at Cornerstone Macro and former Fed staffer.
The problem facing the Fed is that it normally responds to recessions by cutting short-term interest rates. In 2008, for example, it cut rates by more than 4 percentage points, down to zero.
Today, short-term interest rates are below 1.5 percent, and Fed officials don’t expect them ever to rise above 3 percent, for a variety of reasons related to the workings of the global economy.
That means that if the economy were to face another downturn, the Fed would be limited in its ability to lower rates to boost it.
In that scenario, a price-level target or a nominal-GDP target would require the Fed to commit to extraordinary measures, such as more quantitative easing, to stimulate the economy. That commitment could be, in a way, self-fulfilling, as investors would see that the Fed was set to engage in stimulus and would buy bonds themselves, bidding up interest rates.
For her part, Yellen said in June that the question of revising the 2 percent inflation target for such a scenario is “one of the most important questions facing monetary policy around the world in the future.”
Now, the question is coming to the forefront just as President Trump is overhauling the Fed’s personnel. A major question is whether Jerome Powell, his nominee to replace Yellen as chairman next month, would be interested in airing a debate on a price-level or nominal-GDP targets.
“It’s not the kind of thing that would happen unless a Fed chair wanted to encourage the conversation,” said David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution, which is set to host an event Monday featuring two Fed officials on the possibility of changing the 2 percent target.
Whatever Powell’s thoughts, any chances would have to achieve consensus within the Fed and avoid criticism from outside.
Members of Congress would likely chime in. The idea of a price-level target or nominal-GDP target could elicit criticism from some Republicans who have criticized Yellen and Bernanke for not pursuing tighter money policies.
At the same time, the idea of level targets could appeal to House Republicans, who have advanced legislation aimed at making the Fed more predictable in its communications. Some Republicans have expressed openness to the idea of nominal-GDP targeting, a framework that would entail less decision-making by the Fed chairman.
All that lies in the future, though. “I suspect that they will talk about it for a long time before making a decision one way or the other,” Perli said.