This commentary was written by Dr. Daniel Thornton of D.L. Thornton Economics. Thornton spent over three decades at the St. Louis Fed as vice president and economic advisor.
The first thing to notice in the revision of the FOMC’s Longer-Run Goals and Monetary Policy Strategy is the Fed’s increased importance. The previous and revised statements begin with the nearly identical statement that “Employment, inflation, and long-term interest rates fluctuate over time in response to economic and financial disturbances.”
The 2012 statement followed this with, “monetary policy actions tend to influence economic activity and prices with a lag.” The revised statement follows with, “Monetary policy plays an important role in stabilizing the economy in response to these disturbances.”
The 2020 statement goes on to explain how this is done: “The Committee’s primary means of adjusting the stance of monetary policy is through changes in the target range for the federal funds rate.”
But that’s exactly how the Fed has implemented monetary policy from the late 1980s when the FOMC began using the federal funds rate as its policy instrument to Lehman Bros. bankruptcy announcement on September 15, 2008. The only difference, which is not substantive, is before December 2008 the FOMC set a numerical target for the rate; after December 2008 it set a target range, with the midpoint of the range being the effective target. Conclusion: There is no substantive change in the way the FOMC implemented monetary policy.
However, the revised statement goes on to say:
The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average. Therefore, the federal funds rate is likely to be constrained by its effective lower bound more frequently than in the past. Owing in part to the proximity of interest rates to the effective lower bound, the Committee judges that downward risks to employment and inflation have increased. The Committee is prepared to use its full range of tools to achieve its maximum employment and price stability goals.
The statement that “The Committee judges that the level of the federal funds rate consistent with maximum employment and price stability over the longer run has declined relative to its historical average,” cries out for an explanation. Of course, none is given. So let’s consider whether there is any economic rationale why “the level of the federal funds rate consistent with maximum employment” should have declined.
First, note that the federal funds rate averaged 5.7% from January 1955 to August 2008, but just 0.6% since. That’s a nearly 10 fold reduction! Over the same periods, CPI inflation averaged 4.1% and 1.5%, respectively. Hence, the ex-post real federal funds rate averaged 1.6% and -0.9% over the two periods, respectively. The 2.5% decline in the average real federal funds rate is dramatic; even shocking!
Output growth has trended down since 1970, but averaged 2.3% from June 2009 through December 2019. It is hard to imagine that the 0.6 percentage point drop in the economy’s growth rate could account for such a large decline in the nominal and real federal funds rate.
There doesn’t appear to be any employment changes that could account for such a change either. The unemployment rate was trending up from January 1970 until December 1982, but has trended down since.
The employment to population ratio trended up from the early 1970s to late 2000 and declined since, but the level was higher in December 2019 than any time between 1948 and 1984. None of this seems consistent with the FOMC’s contention.
Furthermore, if the Fed can’t explain why this has happened, it is difficult to understand why it expects it to continue over the “longer-run.” Conclusion: The Fed’s statement is baffling!
The next statement is equally baffling:
“The maximum level of employment is a broad-based and inclusive goal that is not directly measurable and changes over time owing largely to nonmonetary factors that affect the structure and dynamics of the labor market. Consequently, it would not be appropriate to specify a fixed goal for employment; rather, the Committee’s policy decisions must be informed by assessments of the shortfalls of employment from its maximum level, recognizing that such assessments are necessarily uncertain and subject to revision. The Committee considers a wide range of indicators in making these assessments."
To paraphrase a line from the movie Blazing Saddles, the statement is an example of authentic Federal Reserve gibberish. At best, it’s a cumbersome way of saying the Fed will no longer measure full employment—the maximum level of employment—by looking at the unemployment rate; it will no longer use the Phillips curve. At worst, it says, “we don’t know what the maximum level of employment is or how to measure it or estimate it, but we’ll know it when we see it.”
The statement is clear about these facts: (a) It is not directly measurable. (b) It changes over time with changes in nonmonetary factors, i.e., in ways the Fed can’t control. (c) The Fed’s assessment of it will be uncertain and subject to revision. (d) It will be determined by the Fed’s assessment of a wide range of unspecified indicators. (e) In spite of all this uncertainty, the Fed will conduct monetary policy based on its assessment of it. Conducting policy this way achieves one thing. It guarantees the Fed will never make a mistake. It will always have an excuse for why its policy failed no matter what happens.
Finally, the FOMC decided to change its inflation target from 2% to an average of 2% over some unspecified time horizon. Even more bizarre, the FOMC justified this move saying:
In order to anchor longer-term inflation expectations at this level [2%], the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.
This makes absolutely no sense! Which policy is more likely to anchor expectations at 2%, one that says we are going to work to keep inflation at 2%, or one that says we are going to keep inflation with an unspecified range of 2% over an unspecified period of time?
And yes, the question is rhetorical.
Inflation averaged just 1.4% since the FOMC established its 2% target at its January 2012 meeting. Consequently, inflation could average 6% for two years and the average inflation rate since January 2012 would only be 2.3%, well within the FOMC’s range of no action. This change seems like a prescription for higher inflation (for more discussion of this point, see Stein Brothers).
The FOMC is playing with fire. The evidence here and elsewhere is that once inflation gets going it is very difficult to stop. As I pointed out in Limits of Monetary Policy, while the Volcker Fed is believed to have ended the Great Inflation of the 1970s and early 1980s, economists don’t agree on how it did it, by reducing money growth or raising interest rates. In any event, it’s end was accompanied by back-to-back recessions. Taken together, as some have argued they should be, they would constitute the longest and most severe post-war recession.
Nevertheless, this change is congruent with the FOMC’s statement about how it will conduct monetary policy to achieve the maximum level of employment in that whenever inflation deviates from 2%, the FOMC is not responsible for it. It’s due to other things.
Conclusion: The Fed is going to keep its interest rate policy low for the foreseeable future regardless of what happens to employment or inflation. No matter what happens, we are not responsible.
By conducting policy in accord with this document the Fed will preserve its unbelievable record of not making a single mistake in over 100 years of its existence.
This is a Hedgeye Guest Contributor piece written by Dr. Daniel Thornton. During his 33-year career at the St. Louis Fed, Thornton served as vice president and economic advisor. He currently runs D.L. Thornton Economics, an economic research consultancy. This piece does not necessarily reflect the opinion of Hedgeye.