The Federal Reserve’s oscillating “go-stop” monetary policy of the 1970s was a function of shifting priorities. During the “go” phase, policymakers held interest rates artificially low throughout the initial stages of economic expansion in an effort to push the unemployment rate down. Inevitably, inflation would rise to unacceptable levels, at which point the “stop” phase kicked in. The steep rise in interest rates required to curtail inflation sent the economy into recession.
That pattern is visible in Federal Reserve policy today. Fed officials acted quickly and reasonably to lower interest rates to zero when the economy shut down in March 2020. But in trying to drive unemployment lower, the Fed held interest rates near zero for two full years—long after it became apparent that the economy was recovering robustly. As a result, inflation has risen to levels not seen since the early 1980s. Now, policymakers are raising rates rapidly, expressing determination to get inflation back under control. But higher rates will also lead to slower economic growth—and possibly another recession.
As in the 1970s, today’s Fed is careening between fighting unemployment and fighting inflation. What threw it off balance, after decades of low and stable inflation? And what will it take to restore that balance? Answers lie in three changes that the Federal Reserve made to its long-run monetary policy strategy statement in August 2020.
First, central bankers emerged from their strategic review increasingly focused on “downside risks to employment and inflation.” While understandable as a reaction to the extended period of sluggish growth and slow inflation that followed the financial crisis of 2007–08, this change in emphasis left the Fed vulnerable when, to everyone’s surprise, inflation did rise sharply in 2021.
Second: while the revised statement makes clear that the Fed rightly takes responsibility for stabilizing inflation around a long-run target of 2 percent, it also reveals a shift in policymakers’ objectives for employment. Before 2020, monetary policymakers reacted to deviations of employment both above and below its long-run level. The new strategy places exclusive emphasis on “shortfalls of employment from its maximum level.” Once again, this left Fed officials ill-prepared when labor demand recovered strongly in 2021, even as labor supply continued to be constrained by lingering effects of the shutdowns.
Third, the penultimate point in the revised strategy statement tellingly deletes a key phrase. Previously, the Fed described itself as taking “a balanced approach” in case its dual objectives for employment and inflation come into conflict. The 2020 amendment removes that language, thus raising the question: If Federal Reserve policy is not “balanced,” then how should it be described? Unbalanced is exactly how the Fed appears today.
What could the Fed do to rebalance to its monetary policy strategy, and thereby break the reemergent go-stop pattern? Some possibilities suggest themselves. Most obviously, the Fed could simply abandon the 2020 amendments and return to its original statement of strategic principles, first adopted in 2012 and last reaffirmed in January 2019. Those principles weigh equally upside and downside risks to employment and inflation. They allow the Fed to move preemptively, raising rates gradually in the early stages of recovery and expansion to prevent inflation from rising in the first place—and thereby setting the stage for sustained growth in employment, with low inflation, instead of facilitating boom-bust cycles. And they call, explicitly, for “balance” in the Fed’s response to changes in employment and inflation.
A second possibility would be for the Fed to adopt and follow an explicit monetary policy rule, of the kind first proposed by John Taylor in 1993. The Taylor rule offers a simple formula according to which the Fed would raise interest rates when inflation goes up and reduce rates when inflation goes down. The Taylor rule also calls for the Fed to increase interest rates when GDP rises and unemployment falls, and to reduce interest rates when GDP falls and unemployment rises. Most important of all, the Taylor rule reminds Federal Reserve officials of the dangers of oscillating between exclusive concern for unemployment and exclusive concern for inflation. Instead, the Taylor rule generates a consistent response to unemployment and inflation that is always in balance.
Of course, these two possibilities are not mutually exclusive. Perhaps it would be best if the Fed reverted to its pre-2020 policy strategy and adopted a Taylor rule to implement that strategy. Either way, however, the Fed must make a priority of restoring balance to its monetary policy framework.
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