I take Jerome Powell at his word when he says that he and his colleagues at the Federal Reserve are determined to get inflation back to its 2% target. And I’m sure they understand how important it is that people believe this promise. Any doubt on the matter will make their job vastly more difficult. So, as conditions change, they have to explain adjustments to monetary policy in a way that makes the commitment credible rather than calling it into question.
Quite a challenge, especially when the economy is being shocked from various directions. The recent cut in the policy rate and subsequent discussion of the Fed’s thinking illustrate the problem. The cut made sense, and the reasoning could have been simply explained. But the actual explanation was needlessly complicated and, partly as a result, less persuasive. By blurring the message, this excess of complexity runs the risk of unsettling expectations.
A simpler explanation would have gone something like this:
Consistent with our 2% inflation target and our estimate of trend growth in output of roughly 2%, we wish to see demand increasing by roughly 4% a year. Demand has been growing faster than that, but it’s gradually decelerating and we think it will continue to decelerate at an appropriate pace with the policy rate cut to 4%-4.25%. If it doesn’t decelerate as we expect, we’ll raise the rate; if it decelerates too abruptly, we’ll cut again.
Compare this with the actual explanation. I’m paraphrasing:
There are so many moving parts, our heads are spinning. Depending on how you measure it, inflation seems to be stuck above the 2% target. Tariffs are pushing prices up — less than many expected, for now, but more is to come. Then again, this bump in inflation will most likely be short-lived. At the same time, the labor market is cooling. We’re still at full employment but maybe not for long if we don’t adjust the policy rate. Hard to be sure because the jobs numbers are all over the place, partly thanks to the immigration crackdown. Heightened uncertainty could depress consumption and investment. Yet asset prices are soaring. Overall, the balance of risks to the dual mandate (full employment and low inflation) has changed, suggesting a cut in the policy rate. But rest assured, after this modest cut, monetary policy remains slightly and appropriately restrictive, based on where we stand in relation to the “neutral rate” that neither adds to nor subtracts from demand. By the way, we think that rate is about 1%, inflation-adjusted, but we don’t really know.
Notice that the complicated explanation can be read as consistent with the simple explanation. The most forgiving reading of the complicated explanation actually boils down to the simple explanation. In particular, the claim that policy is still at least somewhat restrictive parallels the simple explanation’s emphasis on decelerating growth in demand. The crucial difference is that the simple explanation is clear about what “restrictive” means (slowing growth in demand) and what you do if the policy rate turns out to be less restrictive than you want (raise it).
The complicated explanation muddles this up by putting the “neutral rate” at the center of the discussion. This focus is awkward, first, because the meaning of neutral rate changes according to context. The long-term neutral rate matches the supply of savings to the demand for savings when the economy is in equilibrium at full employment with stable inflation. That’s an interesting number, but not much help for the purposes of short-term monetary policy.
The short-term neutral rate — the one that’s “neutral” here and now — has to reckon with inflation that isn’t stable, shifting unemployment, and any number of confounding, fluctuating pressures: changes in fiscal policy, tariff shocks, productivity shocks, you name it. You can estimate it by plugging in values for all such factors, but the range of estimates is bound to be wide, and the number, correctly measured, is in constant motion. Again, as a practical matter, you can better judge whether the rate is above or below “neutral” for monetary-policy purposes by asking whether growth in demand is falling or rising. Go directly to the simple explanation.
Last week, the Fed’s newest recruit, Stephen Miran, gave a talk that inadvertently illustrated the problems with the neutral rate, explaining why he thinks it’s a lot lower than most of the Fed’s other policymakers appear to believe. He subtracts between 62 and 73 basis points for the effect of tariffs (because they raise revenue and add to national savings), 36 basis points for the immigration crackdown (because slower population growth reduces the demand for investment), and between 6 and 31 basis points for recent tax changes (which, he argues, will reduce the federal budget deficit, adding further to savings). He also looks at factors pushing the other way, market-based measures of the neutral rate and other complications, including temporary distortions to prices (notably, the lag before slowing rent increases affect measures of inflation) and output (deregulation and tax policy will raise potential output, which is disinflationary).
Give the man credit for showing his workings. But all such estimates are questionable. Miran’s also appear to contradict his own earlier analyses. The idea that the current stance of fiscal policy is adding to savings and reducing the neutral rate seems especially outlandish. The main point, though, is that this entire exercise distracts attention from what matters most for monetary policy: Is growth in demand on a path consistent with 2% inflation?
Advocates of demand targeting — otherwise known as nominal-GDP targeting — have long recognized that it has other advantages apart from simplicity, and these are especially valuable in current circumstances. Shocks such as tariffs, which push prices up and employment down (at least initially), send the Fed mixed signals. Which part of the dual mandate should it prioritize? Instead of asking for a balance of risks, a target for demand lets the central bank be agnostic. If demand stays on track, the policy rate stays the same — as opposed to rising to curb inflation or falling to spur employment. In effect, instead of wrestling with an impossible dilemma, the Fed is allowed to ignore it: The demand target embeds the idea of “looking through” short-term supply-side fluctuations. If demand stays on track, inflation will end up back on target, and temporary overshoots of inflation won’t unsettle expectations.
To be clear, a target for demand doesn’t resolve the endless complications that underlie forecasts for output and inflation. Making a good forecast of NGDP arguably requires the Fed to weigh factors of the sort that Miran discussed, and many others besides. Even so, organizing the discussion and presentation of Fed policy around demand puts the focus where it best belongs. It would promote effective communication, more realistic assessments of what the Fed can and can’t do, and faster correction of policy mistakes.
In August, following the latest periodic review, Powell announced a change in Fed’s so-called “framework.” It was something of a non-event. The Fed dropped its previous idea of aiming for an overshoot of inflation to make up for a series of persistent undershoots because, as Powell rightly noted, it had “proved irrelevant.” The good news is that this review isn’t quite done, and changes in the way the Fed communicates its policy decisions are still pending. My advice, for what it’s worth: Keep it simple, and talk more about demand.
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