The US Federal Reserve has begun a process with vast implications for the global economy: rethinking the framework by which it sets the interest rates that influence prices and lending in the US and just about everywhere else.
To get it right, the Fed first needs to recognize what’s wrong.
At the January meeting of the policy-making Federal Open Market Committee, central bankers emphasized that the new framework must be “robust to a wide range of circumstances.” This is a step in the right direction, given that the current framework, established in 2020, certainly wasn’t robust to the Covid pandemic and its aftermath.
Developed at a time when inflation was consistently falling below the Fed’s 2% target, the 2020 framework committed to aiming for above-target inflation to compensate for prior shortfalls. Specifically, the Fed pledged to keep short-term interest rates near zero until three conditions were met: The economy had reached maximum sustainable employment, inflation had reached 2%, and inflation was expected to stay above 2% for some time. Moreover, the “lift-off” from zero couldn’t happen until the central bank had completed the asset-purchase program known as quantitative easing – a long process that wouldn’t even begin until substantial progress toward the three conditions had been made.
As a result, the Fed was very late in responding to a strong economy, a tight labor market and soaring inflation. By the time lift-off happened, in March 2022, real output was rising rapidly, the unemployment rate was below the level officials considered sustainable and the Fed’s preferred measure of inflation had exceeded 5%.
Despite this compelling evidence, there’s still debate about whether the Fed’s policy framework was at fault. Some say the central bank just made a forecasting error, for which it later had to compensate by tightening monetary policy aggressively. Chair Jerome Powell has leaned into this explanation, saying that the framework “was more irrelevant than anything else.” I don’t buy it: If the Fed had ignored the framework and paid more attention to the policy rules it typically follows, it would have started raising short-term rates about a year earlier.
