The Fed gives up

What the Fed's retreat tells us about the modern world

I imagine there will be lots of pundits offering takes on the new Fed policy framework. But the most interesting aspect of the document is not the question of whether it is good or bad, rather its most striking characteristic is an almost complete lack of ambition. I came of age during the 20th century, when policymakers were full of ideas. Now, they seem to have given up. Or perhaps I should say the experts have given up—the fools are full of exciting plans. European readers might see some parallels with the situation in the EU.

Back in 2020, the Fed produced an excellent proposal for “flexible average inflation targeting.” If implemented, this would have been fairly similar to nominal GDP level targeting. Inflation would have averaged about 2% during the first 5 years of the 2020s. Unfortunately, the policy was never implemented, and the actual Fed policy was quite inflationary. PCE inflation averaged 3.65% between December 2019 and December 2024. NGDP overshot the previous (4%) trend line by even more, averaging 6.27%.

So what lessons should we learn from a situation where the Fed announces an excellent new policy and actually implements a very different and far inferior policy? If it were up to me, I’d have the next policy review commit to doing the policy the Fed announced in 2020, not the policy that was actually implemented.

The Fed has adopted neither of these two options. Instead, it has basically given up on the whole idea of reforming monetary policy based on the insights of our top monetary theorists. They’ve removed the useful policy reforms of the 2020 document (average inflation targeting) but promised not to repeat the mistake of doing the very different policy that was actually implemented during 2021-22. In a sense, we are back to the 2% flexible inflation target announced back in 2012 and informally adhered to for the most part since the early 1990s.

I agree with much of Jay Powell’s appraisal of the current situation as outlined in his Jackson Hole speech, but this raised an eyebrow:

It is also possible, however, that the upward pressure on prices from tariffs could spur a more lasting inflation dynamic, and that is a risk to be assessed and managed. One possibility is that workers, who see their real incomes decline because of higher prices, demand and get higher wages from employers, setting off adverse wage–price dynamics. Given that the labor market is not particularly tight and faces increasing downside risks, that outcome does not seem likely.

I have no idea whether wages will accelerate over the next year. But this is not a useful framework for thinking about the problem. As we saw in the 1970s, fast rising wages do not require a tight labor market. And if workers do demand higher wages, that will not trigger a persistent inflation problem (holding NGDP growth constant), rather it will trigger higher unemployment. If a major wage push is associated with persistent inflation, the cause will almost certainly be easy money policies that boosted NGDP growth (as in 2021-22).

In approaching this year's review, a key objective has been to make sure that our framework is suitable across a broad range of economic conditions. At the same time, the framework needs to evolve with changes in the structure of the economy and our understanding of those changes. The Great Depression presented different challenges from those of the Great Inflation and the Great Moderation, which in turn are different from the ones we face today.

The phrase “at the same time” is a major red flag for me. If you don’t have a single policy framework that is appropriate for all of the various “challenges” cited in this paragraph, then it will not be capable of dealing with unforeseen circumstances. It is easy to run monetary policy when things are going well; any worthwhile framework needs to focus on creating a policy regime that works under usual unusual conditions. The Fed seems to have thrown in the towel, abandoning any attempt to move even slightly in the direction of level targeting. Nothing in the new framework would address what went wrong in 2008-09.

We concluded that the emphasis on an overly specific set of economic conditions may have led to some confusion, and, as a result, we made several important changes to the consensus statement to reflect that insight. . . .

Second, we returned to a framework of flexible inflation targeting and eliminated the "makeup" strategy.

Here the Fed misdiagnoses what went wrong in 2021-22. They thought the high inflation was produced by the “make-up” strategy. Not so. The actual problem was the asymmetric nature of “flexible average inflation targeting”. They should have fixed the problem by no longer focusing primarily on the need for making up undershoots and instead emphasized that it was equally important to correct overshoots. Make the policy symmetrical

Some will argue that correcting the 2021-22 overshoot would have been painful. But that’s missing the point. The primary purpose of an average inflation targeting regime is to prevent something like 2021-22 from occurring in the first place. Policy would have been dramatically less expansionary under an actual FAIT regime, and NGDP growth would have averaged close to 4%/year.

To be sure, the new framework could have been much worse. They’ve made it clear that policy will be symmetrical, which they didn’t do in 2020. (Unfortunately, they threw out the baby with the bathwater, removing make-up policies in both directions.) Another plus is that they’ve re-emphasized the 2% inflation target and rejected any form of fiscal dominance. Fiscal dominance still might occur at some point in the future, but it presumably won’t happen under Powell’s watch (and I doubt it would occur under Waller or Warsh.)

There’s a debate about whether the Fed needs such a large research staff. In principle, I’d say it’s worth spending a lot of money on monetary policy research, as the costs of bad policy can run into the trillions. But if this is the best the Fed can do, then they’ve basically given up. In that case, what’s the point of employing hundreds of economists to work on policy?

More broadly, isn’t this the story of the 21st century? The first half of the 20th century was a horrifically bad period for government policy, but things improved dramatically during the latter part of the century. As we entered the 21st century, the future looked very bright. A quarter century later, the public has become cynical and the elites have basically given up. There’s a lack on energy, enthusiasm, spirit, optimism. I sense the end of an era. God only knows what comes next, when the grown-ups have left the room.

Artist Name: Achille-Jacques-Jean-Marie Devéria (French, 1800-1857), from the Norton Simon Museum.