Last week, the Center on Budget and Policy Priorities’ Full Employment Project published an important new paper—Monetary Rules and Targets: Finding the Best Path to Full Employment—by Haverford’s Carola Binder and Alex Rodrigue (B&R).
The paper takes a close look at a critical aspect of how the Federal Reserve makes decisions about monetary policy: the rules and benchmarks that guide them in meeting their dual mandate of full employment and stable prices. B&R’s work is timely because the Fed’s old toolbox needs an update.
First, as B&R show, the Fed has been missing their 2 percent inflation target for about four years running. Importantly, this downside miss has persisted even as actual unemployment has fallen to match the Fed’s estimate of the “natural rate”—i.e., their estimate of the lowest unemployment rate consistent with stable inflation, which may well be too high.
Second, recent and new work by macroeconomists Larry Summers, John Williams, Olivier Blanchard, and others shows that interest rates across the globe appear to have undergone a structural downshift in recent years. Another key Fed parameter—their neutral interest rate target (the rate that is neither stimulative nor contractionary)—is also likely to decline. Both of these developments must ultimately be reflected in Fed policy.
Third, B&R point out that some outsiders are pushing the Fed to rely on some version of the “Taylor rule,” an equation derived by economist John Taylor that describes the Fed’s historical rate-setting behavior as a function of inflation and economic slack. But B&R argue that adherence to a rigid, simple equation would undermine the Fed’s discretion at crucial economic moments: “Following the Great Recession, for example, the original form of the Taylor rule would have directed the Fed to raise interest rates above zero in 2011, years before the labor market recovery was near completion, which would have slowed the recovery even further.”
So what tools should be in an updated Fed toolbox? B&R provide a useful table, shown below, which summarizes a set of monetary policy rules and targets along with the authors’ judgements as to which tools are best for hitting full employment. The two targeting rules they view as most promising in that regard are nominal GDP targeting and nominal wage targeting.
Under NGDP targeting, the Fed “would choose and announce either a target growth rate for NGDP or a target path for NGDP and adjust its policy rate to help achieve the target in the medium run; the bank would lower rates if NGDP were below target and raise them if NGDP were above target.” Since wages are the largest component of nominal GDP, targeting aggregate wages would resemble NGDP targeting, while wage targeting could alternatively focus on the growth rate of nominal wages (as B&R note, Josh Bivens has suggested 3.5 percent for an average nominal wage growth target).
Because nominal growth equals real growth plus inflation, both nominal wage and NGDP targets implicitly account for inflation while also focusing on indicators more likely to promote the goal of full employment. B&R observe that an NGDP target could have highlighted the need for more expansionary monetary policy between 2007 and 2009, potentially spurring policymakers to action sooner and easing the severity of the Great Recession.
Another useful tool reviewed by B&R, especially in the current environment, is price-level targeting. Under price-level targeting, the Fed targets a path for the price level over time. For example, they may decide it’s optimal for the economy if the price index is around 100 today, 103 next year and 106 the year after that. The useful attribute to level targeting is that if instead of hitting 103 next year, the price level is only 102, the public expects the Fed to employ stimulative monetary policy until inflation is back on its path.
How does that differ from current practices and what are its advantages? The Fed currently targets a 2 percent inflation rate, but it is ambiguous as to whether this is an average target (meaning that if you’re below it for a while you then need to be above it for a time) or a ceiling. If Fed officials view it as a ceiling, as their statements sometimes suggest, they’ll likely tighten monetary policy once they hit it even if they’ve been missing 2 percent for years and tightening means slowing job and wage growth that has eluded too many workers in recent recoveries. Under price-level targeting, there is no such ambiguity. If inflation is below the target path, the Fed tries to increase price growth, regardless of the percent change in prices.
We hope Fed officials and others concerned about the intersection between monetary policy and full employment carefully consider the typology offered in B&R’s paper. The authors have done some very useful work in illuminating the policy path toward full employment.