The Rules of the Game Are Changing on the Fed
When asked why his opinions frequently changed, economist John Maynard Keynes is said to have responded with some variation of "When the facts change, I change my mind." Well, it's time the Federal Reserve changed its thinking on monetary policy.
Economies are becoming increasingly driven by real and financial asset prices, meaning financial stability can no longer be relegated to the Fed's regulatory and supervisory role. Financial stability has become more than an equal alongside full employment and stable prices in the objectives of monetary policy.
The price-targeting framework was introduced when it was thought that ensuring stability in prices tied to the economic cycle were essential to the economy's performance. However, this policy framework is losing its effectiveness since there is virtually no cyclical volatility in core consumer prices anymore. In the last 20 years, core consumer prices as measured by the personal consumption expenditure deflator, or PCE, increased 1.7 percent on average, sitting in a range of 0.9 percent to 2.5 percent. Almost 95 percent of all of the monthly readings of the core PCE were in the range of zero to 0.2 percent. The results are similar for the core consumer price index, or CPI.
Prices that matter the most now are tied to the financial cycle. Real and financial asset prices have advanced at relatively high rates, becoming unhinged from prices tied to the economic cycle. Prior to the 1990s, the cumulative gains in real and financial asset prices more or less paralleled growth in household income. Yet during the economic upturns of the 1990s, 2000s and the current cycle, the cumulative price gains have outpaced income gains by 25 percent to 30 percent. These gains have engendered large increases in wealth, lifting the ratio of household net worth to income to higher highs, and in the process created a new source of purchasing power and collateral to support borrowing and spending.
History shows that this newfound source of liquidity can readily disappear, and the fallout in the real economy can be severe, as is evident from the long and deep economic downturn of 2007-2009. That example alone should be a wake-up call that asset price cycles and the economy are more closely connected and that shifts in balance sheets and asset prices must become a basic part of the monetary policy framework.
Each generation of policy makers has had to deal with fundamental changes in the economy and finance, and had to adapt and alter the policy framework to the new set of realities. Jerome Powell, the new Fed chairman, and other policy makers must recognize that the price-targeting regime -- along with the asset purchase program -- has directly and indirectly created an unhealthy balance between the economic and financial cycles so much so that it is endangering the Fed's natural role of financial stability.
In the short run, the Fed needs to rethink its communication policies. Although transparency of policy can be a helpful tool, it also can do harm. Indeed, as policy makers communicate how they will set policy in order to achieve their price target objectives, they give investors the game plan (i.e., the policy rate forecast and even the scale of the asset purchase program) before the game is even played. That invites lowered risk premiums while encouraging speculation in riskier assets.
Even minor tweaks, such as being less transparent about what they plan to do and when, raising rates in a less predictable or measured way, or even raising official rates at Federal Open Market Committee meetings that are not followed by a press conference, would make monetary policy less predictable while adding some risk to investing.
No one is advocating that asset prices be the sole target of monetary policy, but the fundamental problem with the current operating framework is that it is not sufficiently broad and flexible to assess all the prices that matter to the economic cycle. Policy makers have two choices: 1) create a broader price measurement for policy purposes, or 2) change the operating framework entirely.
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