About the author: Ben S. Bernanke was chairman of the Board of Governors of the Federal Reserve System from February 2006 through January 2014.
Federal Reserve Chair Jerome Powell has a new term in office but no time for a victory lap. The highly unusual recovery from the pandemic recession, including a sharp increase in inflation, has raised the question of whether the Fed’s new monetary policy framework is right for the times.
Powell announced the new framework, called flexible average inflation targeting, or FAIT, in August 2020. The new framework kept the Fed’s 2% inflation target but made two key changes.
First, the Federal Open Market Committee agreed to try to make up for past undershoots (though not overshoots) of the inflation target. If inflation had been below 2% for a while, as had been the case for much of the past decade, the FOMC would compensate by allowing inflation to run “moderately above 2% for some time.” The goal was to demonstrate that the target is truly symmetric, with no tendency for inflation to remain either below or above target for long periods. In contrast, under the traditional approach, policy makers ignored the size or duration of past misses and simply tried to reach the target over time, letting bygones be bygones.
Second, the FOMC would no longer, as it had at times in the past, try to forestall possible inflation pressures by tightening policy in response to improving labor market conditions, even in the absence of actual increases in inflation. In the new framework, the FOMC forswore such “pre-emptive strikes” on inflation. Instead, to avoid inadvertently snuffing out nascent job-market recoveries, it said that an improving labor market would not in itself be sufficient reason to tighten, so long as inflation seemed controlled.
However, last year and this year, too-high rather than too-low inflation became the FOMC’s main problem. Some influential economists, including former Treasury Secretary Larry Summers, Olivier Blanchard (former chief economist of the International Monetary Fund), and Jason Furman (a former top adviser to President Obama), were early in voicing concerns that powerful fiscal stimulus and easy monetary policy would overheat the economy, leading either to a 1970s-style inflation or to a hasty tightening by the Fed that would disrupt the economy and markets. Inflation did pick up much faster than Fed policy makers had expected. By March 2022, the 12-month increase in the prices of personal consumption expenditures, excluding the volatile food and energy categories, reached 5.2%, well above the Fed’s target. As measured by the better-known consumer price index, including food and energy prices, inflation that month reached a shocking 40-year high of 8.6%.
How did this happen? Over the course of last year, the FOMC had become increasingly worried about inflation. But policy makers did not announce an end to their securities-purchase program until November, and the first rate hike—of a quarter point—did not come until this March. In May, the FOMC raised its policy rate an additional half-percentage point and announced a plan to reduce the size of its securities holdings. With the Fed now focused on inflation, a serious tightening campaign is underway. But, in retrospect at least, some Fed policy makers and many outside economists agree that earlier action against inflation would have been desirable.
Was the new FAIT framework responsible for the delay in acting? On the margin, FAIT put more emphasis on achieving a strong labor market—which the FOMC had (correctly) characterized as providing “broad-based and inclusive” benefits. It thus may have made policy makers a little more patient about responding to the first signs of inflation. However, the more important reason the FOMC did not act earlier was not the policy framework but the unusual effects of the pandemic, which made the situation more difficult to diagnose.
The pandemic scrambled usually reliable indicators of labor market strength. In mid-2021, Fed policy makers saw the economy as still far from full employment. The unemployment rate in June was 5.9%, well above the prepandemic rate of 3.5%, and millions fewer people held jobs. However, in a pandemic economy, these indicators disguised the labor market’s true strength. Many people had put off returning to work, because they needed to take care of family members, were concerned about getting sick, or were rethinking life priorities. As is now evident in sharply rising wages and the difficulty of employers in finding workers, the labor market over the past year has been more robust than conventional measures suggested.
In addition, the FOMC also saw the uptick in inflation in the middle of 2021—inflation ex food and energy prices was running at about 3.5% over the summer—as largely reflecting temporary forces related to the reopening of the economy. These included the reversal of price declines in sectors hit hard during the pandemic (hotel rates, airfares), supply-chain bottlenecks, and a sharp shift in consumer spending away from services that led to higher prices for vehicles, appliances and other durable goods. These supply-side shocks, including the disruptions to labor supply, seemed likely to ease as the virus came under control. Supporting the Fed’s view that the inflation surge was likely to be temporary, inflation expectations (as measured by surveys of households and businesses and the yields on inflation-indexed government bonds) generally remained moderate despite the pickup in price increases.
The pandemic supply shock was indeed an important source of inflation but it would prove larger and more enduring than the FOMC expected. Further increases in energy and food prices associated with the war in Ukraine added to price pressures. Inflation expectations over the medium term (the next two to three years) have still not risen much, showing public confidence in the Fed’s resolve, but high inflation has persisted and spread to more sectors of the economy. The Fed’s challenge now is to bring down inflation without inducing a recession—a “soft landing.”
If the Fed’s delay in tightening is explained mostly by the unusual circumstances of the pandemic, rather than by the FAIT framework itself, what does that imply for the framework when it is next reviewed in 2024-2025? I expect relatively modest changes. If inflation falls back to prepandemic levels and too-low inflation re-emerges as a potential problem, then the “overshooting” aspect of FAIT will still be useful. If inflation does not fall to earlier levels, then overshooting will never (or rarely) be necessary. But neither will that provision cause problems and so it will likely be retained, just in case it is needed in the future. A bigger problem is the difficulty the FOMC has had in determining when the economy is at full employment. A revised framework should more explicitly acknowledge the difficulty not only of forecasting full employment but of identifying it when it occurs. By doing so, the FOMC can retain its commitment to a strong labor market but also give itself more flexibility to respond promptly to inflation when needed.
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This essay was adapted from 21st Century Monetary Policy: The Federal Reserve from the Great Inflation to Covid-19. Copyright © 2022 by Ben S. Bernanke. Used with permission of the publisher, W. W. Norton & Company. All rights reserved.