Monetary Policy Renormalization
Philadelphia Fed Policy Forum - The New Normal for the U.S. Economy
December 4, 2015
December 4, 2015
There has been a great deal of public conversation about the onset of what is called “monetary policy normalization.” The website of the Board of Governors of the Federal Reserve System defines “monetary policy normalization” as the process of raising the fed funds rate and other interest rates to more normal levels and reducing the size of the Federal Reserve’s securities holdings.1 This definition leaves unstated what kind of strategic framework will guide the Federal Open Market Committee’s (FOMC’s) decisions about the target range for the fed funds rate and the size of the balance sheet. However, at least to my ears, the term “normalization” connotes that the FOMC is aiming to return to a strategic framework that closely resembles the one used prior to the financial crisis. In this talk, I argue that the FOMC would be better served by instead turning to a different strategic framework. My argument unfolds with three points.
First, I provide a characterization of the FOMC’s pre-2008 policy framework. Many observers have noted that this framework was largely grounded in the Taylor Rule.2 I argue that the Taylor Rule requires the central bank to tolerate persistent inflation and employment shortfalls in order to limit deviations of the fed funds rate from historically normal levels.
Second, I use the public record to document that, as of late 2009, the FOMC felt that it would be appropriate to use its monetary policy tools to foster a relatively slow recovery in both prices and employment. (The recovery that actually unfolded was slower than the FOMC intended in terms of employment, but close to the FOMC’s intentions in terms of inflation.) I argue that the FOMC’s guarded response can be traced back to its pre-2008 policy framework—that is, to the Taylor Rule. Indeed, because of this baseline “normal” policy framework, the FOMC and many outside observers actually saw the Committee as pursuing a highly accommodative policy....
...So the FOMC was not forced to pursue a slow recovery because of constraints on its tools. Rather, the FOMC chose to pursue a slow recovery. In my view, this choice can be traced back to the Committee’s reliance on the Taylor Rule as a key baseline in its thinking. As we have seen, the Taylor Rule is specifically designed to constrain the response of the central bank’s target interest rate to inflation gaps and output gaps. Qualitatively, a desire for low interest rate variability would have important consequences for the FOMC’s perspectives on appropriate monetary policy in late 2009. To achieve a faster recovery, the FOMC would need to add more accommodation and/or slow the pace of its eventual removal of accommodation. Either option would increase the deviation between the time path of accommodation and its eventual long-run level....