What does the Fed really want?

It wants to establish a new monetary policy framework. Recently, several presentations have hammered on this point. In a recent speech, Chicago’s Charles Evans explains:

Specifically, I will talk about Delphic communications as those associated with a well-functioning, well-understood monetary policy framework. A foundation for these communications is a variety of state-contingent responses to economic developments that are well understood and well expected by the public.

I’ll refer to Odyssean communications as those arising when unexpected events expose weaknesses and shortcomings in a Delphic framework. In such times, the need for outcome-based policies is paramount, and policymakers may be compelled to take less-well-understood actions to meet their mandated goals. These actions may dispense with usual norms and could entail entirely new commitments about future central bank behavior. As such, these Odyssean policies might be difficult to communicate and might lack strong credibility. These shortcomings could dilute their effectiveness. So my question is this: How do you convert nonstandard Odyssean policies into a better-understood and more effective Delphic framework?

Well, you do so by strengthening your current monetary policy framework. Ben Bernanke’s recent proposal at the Peterson Institute for International Economics regarding temporary price-level targeting (PLT) is one such example.3

Furthermore, the journey from the Fed’s 2010 policy debates about temporary price-level targeting at the zero lower bound (ZLB) to Bernanke’s recent proposal illustrates the challenges in transforming Odyssean policies into Delphic ones.

In addition to Bernanke and Evans, the “PLT” (Price Level Targeting) alternative has been put forth by others, including Francisco Fed John Williams.

For almost two decades monetary policy makers have discussed, published and debated on the topic of “Monetary Policy in a Low Inflation Environment”. One early readable essay on the subject is this one.

The focus has been on the “dangers” of reaching the ZLB due to low inflation. However, as the charts indicate, it appears that low inflation has no implication for the risk of reaching the ZLB.

The thing that poses that risk, for sure, is the Fed making a gargantuan monetary policy mistake letting NGDP growth turn significantly negative as happened in 2008. The big drop in the level of NGDP was never made up, and the rate of NGDP growth has remained low and stable, consistent with low and stable inflation and very low FF rate.

If too low NGDP growth (additionally at a low trend level) is the major reason for interest rates having difficulty moving up and away from the ZLB, the “best” monetary policy framework is NGDP Level Targeting, not inflation or price level targeting.

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