A new staff paper summarizes the Federal Reserve’s policy framework, as it evolved in the face of the zero lower bound for interest rates. The framework is predicated on the principles of excess stimulus, history dependence, economic conditionality, and credible communication. Its main tools are interest rate forward guidance and asset purchases. A higher inflation target or a nominal income level target is under discussion. The integration of monetary and macro-prudential policies has progressed.

The Federal Reserve’s Framework for Monetary Policy—Recent Changes and New Questions William B. English, J. David López-Salido, and Robert J. Tetlow 
Paper presented at the 14th Jacques Polak Annual Research Conference, November 7–8, 2013 
http://www.imf.org/external/np/res/seminars/2013/arc/pdf/english.pdf

The below are excerpts from the paper. Cursive text and emphasis has been added.

The Fed’s current policy

a. Flexible inflation targeting

“On balance, the Federal Reserve has moved closer to ‘flexible inflation targeting’… [with] emphasis on seeking policy settings that bring both inflation and resource utilization back toward their objectives in the medium term…The Committee will take a ‘balanced approach’ to its two objectives of maximum employment and stable prices when they are not complementary. ”

“The approach taken by the Federal Reserve differs in important ways from a strict inflation targeting regime. Most obviously, the Federal Reserve has, by statute, a dual mandate…A second difference, at least with respect to some inflation targeting central banks is that the Federal Reserve has considerable flexibility regarding the horizon over which it aims to return inflation to its longer-run goal.”

b. Policy principles at the zero lower bound

“The special features of an economy that has spent an extended period at the effective lower bound may justify deviating from the prescriptions of simple rules—even rules viewed as dependable in normal times… a considerable body of research suggests that four robust features characterize optimal rules that are derived in the presence of an explicit effective-lower-bound constraint…

  • The first element of an optimal rule is that it promises that future policy will be more expansionary than usual after the economy no longer faces a binding effective lower bound constraint.
  • A second element of the optimal policy is that it is ‘history dependent’…as an economy facing an effective lower bound constraint becomes mired in a deeper recession, an optimal policy would promise even more stimulus in the future in order to reduce long-term real interest rates.
  • A third element of the optimal policy is that the timing and size of adjustment in policy rates after they rise above the lower bound depends crucially on the evolution of economic conditions.
  • Finally, the role of expectations in such optimal policies implies that such a strategy relies on credible communication that allows the public to understand the policy strategy.”

c. Communication

“In recent years, the Committee has taken a sequence of steps to improve public understanding of its policy objectives…The establishment of a 2 percent longer-run goal for inflation after many years of discussion on the Committee reflected [that] an explicit numerical inflation objective would better anchor inflation expectations and improve central bank accountability…The Committee was less precise with regard to its longer-run employment objective… The Summary of Economic Projections (SEP) offers detailed information on the forecasts of all FOMC participants (the seven members of the Board of Governors and the twelve Reserve Bank presidents) under each participant’s assessment of appropriate monetary policy… At least in normal times, [the Summary of Economic Projections] provided considerable information on the Committee’s longer-term objectives for unemployment and inflation.”

d. Forward guidance for interest rates

“By the end of 2008, with the federal funds rate at its effective lower bound…[the FOMC] began using non-traditional policy tools—specifically, forward guidance regarding the path of the federal funds rate and large-scale asset purchases (LSAPs)—that required increased communications.”

Once the federal funds rate is at its lower bound, communications about the likely future path of short-term rates can influence longer term rates and thus, influence spending. Moreover… it may be desirable to offset the effects of a period at the lower bound by maintaining the funds rate at a lower level than would normally be the case given economic conditions once the economy improves—that is, there are benefits to conditional commitments to lower rates… the FOMC’s use of economic thresholds for the possible timing of the first hike in the federal funds rate can be seen as a way of committing to keep interest rates lower for longer than would otherwise be the case.”

“In December 2012, the Committee changed its language to make the maintenance of a very low federal funds rate explicitly conditional on economic conditions—that is, state-dependent forward guidance. Specifically, it indicated that the ‘exceptionally low range for the federal funds rate will be appropriate at least as long as the unemployment rate remains above 6½ percent, inflation between one and two years ahead is projected to be no more than a half percentage point above the Committee’s 2 percent longer-run goal, and longer-term inflation expectations continue to be well anchored’.”

“Examination of the possible benefits of employing threshold-based forward guidance suggests that thresholds, if understood and seen as credible, can significantly improve economic outcomes. Of course, such guidance could also be delivered by providing the expected date of the first increase in the federal funds rate given the economic outlook. However, as we saw, that approach would likely require a number of changes in the date as the outlook evolved, which could be confusing to the public and undermine the credibility of the forward guidance.”

e. Large-scale asset purchases

“With regard to asset purchases, the effect of purchases on the economy depends on the expected quantity of purchases and the length of time that market participants expect the Committee to hold them… asset purchases have to be carried out over a period of time, and making commitments…is potentially more complicated… given the limited experience with…their effects…and their costs.”

“The current purchase program did not feature a fixed expected size. Instead, the Committee indicated that the purchases would continue until ‘the outlook for the labor market’ improved ‘substantially’ in a context of price stability. This approach is somewhat similar to the use of thresholds for the forward guidance for the federal funds rate in that it describes the economic conditions under which the purchases would end. However, the language employed is less specific, not providing numerical thresholds for particular economic variables.”

Further potential changes to non-conventional policy

“While the Federal Reserve and other major central banks have made significant changes to their monetary policy frameworks in recent years, it is to be expected that these frameworks will continue to evolve.”

“Some observers have suggested that a higher inflation objective, either temporarily or permanently, could help ease the constraint generated by the lower bound on nominal interest rates.”

“In the stylized world of textbook rational expectations models...a credible increase in the target rate of inflation would reduce real interest rates, relax the effective lower bound constraint, and thereby help conventional monetary policy to regain its effectiveness. Moreover, it would also reduce the asymmetric effects of negative shocks on the economy. But reality introduces a number of practical concerns… Whether agents can be expected to come to understand a change in a policy rule, such as a change in the target rate of inflation…without experiencing the regime beforehand, is an open question… [Also] the perceived target rate of inflation [might] overshoot the central bank’s actual target, obliging a subsequent costly contraction.”

“Alternatively, some have suggested that central banks should aim to target the level of nominal GDP… pursuing a nominal income level target implicitly aims to reverse past inflation shortfalls rather than let bygones be bygones, thereby inducing a form of history dependence.”

One appealing feature of a nominal income target in the U.S. setting is that it explicitly recognizes both sides of the dual mandate. Indeed, the equal weights on the price-level gap and output gap would be consistent with a similar degree of concern for both objectives. ”

“The demands on the public’s attention and comprehension imposed by nominal income targeting are arguably more severe than they are for other rule-based regimes. The implications of revisions to the data are a pertinent example. Any monetary policy regime that depends, at least in part, on an informed public, runs the risk of sowing confusion.”

How to integrate financial stability and monetary policy

“The policy response to the crisis and its aftermath has demonstrated the potential complementarities between regulatory and supervisory policies (including both prudential supervision and macroprudential policies) and ‘standard’ monetary policy.”

Policymakers should use regulatory and supervisory tools to limit systemic risks rather than employing monetary policy so long as the ‘macroprudential’ tools are sufficient to greatly limit the risks of financial crisis, thereby limiting the need for monetary policy to deviate from the path that would be taken to best address the traditional monetary policy objectives of stable prices and maximum employment.”

In some cases, tighter policy may help to limit risk taking and accumulations of leverage, and so reduce the odds of a crisis. Moreover, if low interest rates are leading financial market participants to take on excessive risk, then tighter monetary policy may ‘get in all the cracks’.”

The Federal Reserve has applied the information from its financial stability monitoring to its monetary policy decision-making process. Information on financial stability has been reported to the Federal Open Market Committee on a regular basis, and the Committee has discussed the information in the context of its policy decisions. Indeed, as noted earlier, the FOMC statement has explicitly conditioned the size, pace, and composition of asset purchases under the current purchase program on its assessment of the efficacy and costs of the purchases, and some Committee participants have noted specifically that an important possible cost of the program is its effects on financial stability.”

“Since financial stability and monetary policy decisions are bound to be interrelated, there are clear benefits to having them made by the same policymakers…There has been a clear shift in the direction of an increased role for central banks in financial stability. In the United States, as we have emphasized, financial stability has moved back to the forefront of policy discussions, and the Dodd-Frank Act has provided the Federal Reserve, as well as other supervisors, with additional tools to address financial stability concerns.”