How the Fed can stop being the prisoner of financial markets
The Fed in its effort to limit the impact of the pandemic on the economy has provided broad support to every aspect of the economy and the financial system. It’s worth noting that the Fed’s securities holdings, now at $7 trillion, are almost double what they were at the beginning of 2020. Amidst an uncertain economic environment and changing risk of inflation, financial markets have become excessively sensitive to the Fed’s public statements regarding the likely future path of policy. To mitigate the risk of financial volatility caused by changes in monetary policy, markets should respond directly to news regarding economic conditions, and less to policymakers’ commentary. Bordo et al. suggest one solution that would shift the markets’ focus to the key risks to the economic outlook: developing a set of scenarios for the evolution of the economy and give some sense of how they might adjust their balance sheet in each case. They identify three possible scenarios:
- A baseline scenario: employment remains far below its pre-pandemic peak and recovers only slowly over coming years, while inflation remains well below the Fed’s target;
- A benign scenario: a robust recovery fosters rapid growth in economic activity and employment, and the economy returns close to its pre-pandemic trend path by mid 2021;
- A severe adverse scenario: consumer and business sentiment wanes further, leading to sustained high unemployment, further business closures and widespread credit defaults, thereby triggering an adverse feedback loop between the real economy and the financial system as well as persistent deflationary pressures.
Moreover, scenario analysis would not have to constrain the Federal Reserve to follow any rigid strategy or rule. Rather, such an approach might prove helpful in facilitating the Fed’s policy deliberations and enhance the clarity of its public communications. Indeed, explaining its policy strategy clearly might well foster public confidence more effectively than a conventional approach of making and explaining decisions on a “meeting-by-meeting” basis.
Incorporating Scenario Analysis into the Federal Reserve’s Policy Strategy and Communications
Authors: Michael D. Bordo, Andrew T. Levin, Mickey D. Levy
From: Rutgers University, Berenberg Capital Markets, Dartmouth College
How can the Fed move to a rules-based monetary policy
By early 2021 the Fed began to report on rules-based policy in its Monetary Policy Report. However, these changes have not yet affected actual monetary policy decisions and there is evidence of big difference between the rules-based policy and the actions of the Fed. In this paper, Papell and Prodan propose two new policy rules which are consistent with the August 2020 announced change in Monetary Policy Strategy, namely the targeting of average inflation aimed at mitigating shortfalls, rather than deviations, of employment from its maximum level. The rules proposed by Papell et al. are the Taylor (consistent) rule and the balanced approach (consistent) rule. They derive these rules by introducing two modifications:
- They replaced the difference between the unemployment rate in the long run and actual unemployment rate with the minimum between the difference and 0. If the unemployment rate is 3.5 percent and long run level is 4.0 percent, the interest rate is not raised. That is, zero is the minimum of .5 percent (=4.0-3.5) and zero.
- They introduce the assumption that the Fed would not adjust the interest rate if inflation is 2.0 or 2.1 percent; rather it would watch for inflation going above 2.2 percent. Also assumed is that the equilibrium real interest rate is .5 percent.
Policy Rules Consistent with the FOMC’s Longer-Run Goals and Monetary Policy Strategy
Authors: David H. Papell, Ruxandra Prodan
From: University of Houston
