Fed's Monetary Policy Challenges and Opportunities Under Political Pressure

Challenges and Opportunities in the Fed's Monetary Policy

Despite escalating attacks from former U.S. President Donald Trump, Federal Reserve (the Fed) Chair Jerome Powell has performed commendably in managing U.S. interest rates. However, there's still room for improvement in the Fed's broader monetary policy thinking.

At the Jackson Hole Economic Policy Symposium last week, Powell sent a clear signal: the Fed will consider a 25-basis-point cut to short-term interest rates at its September policy meeting. He noted that since current monetary policy is still in a "restrictive range," and labor market weakening risks may appear "quickly," while inflation expectations are stable enough to cope with short-term price increases caused by tariffs, accommodative policy "may" be appropriate. The market's reaction was to raise the probability of a September rate cut to nearly 90% -- but the ultimate outcome still depends heavily on the next employment data.

Of greater long-term significance are the revisions to the overall monetary policy framework that the Fed released concurrently with the symposium. These revisions largely reverse the direction of the last round of framework adjustments.

One reason the Fed failed to control inflation during the COVID-19 pandemic in 2021-2022 was the last round of framework adjustments. That prior framework was passed against a backdrop of long-term low inflation, encouraging inflation to overshoot its 2% target to compensate for past inflation undershoots, and prioritizing full employment, which led policymakers to keep interest rates at zero even when the unemployment rate fell to unsustainable levels and consumer price inflation rose by more than 5% year on year.

Today, the Fed has returned to a "symmetric average inflation targeting regime": inflation above target and inflation below target will be treated equally. The Fed will seek to maintain the "highest level of employment consistent with price stability," rather than eliminating employment "shortfalls" or ensuring that employment is "broad and inclusive."

As Powell stated, preventing short-term interest rates from falling into the zero lower bound “remains a potential concern,” but is no longer “our primary focus.” The reason is that the “neutral” interest rate (the interest rate that neither inhibits nor stimulates growth) has risen, providing the Fed with more room to cut interest rates.

For now, these adjustments are commendable. They restore the Fed's ability to act preemptively when there is a risk of inflation overshooting its 2% target, and reasonably place employment and price stability goals on a more equal footing. But these adjustments do not fully address some key flaws in the Fed's monetary policy implementation process.

Specifically, the Fed needs to establish a cost-benefit framework to guide its use of the quantitative tightening (QT) tool. The cost of the Fed's 2020-2022 quantitative easing program, calculated by forgoing interest paid to the U.S. Treasury, will exceed $500 billion. In addition, the Fed should better distinguish between two types of large-scale asset purchases: one for purchases made to restore market function, and the other for purchases made to provide additional monetary policy stimulus after interest rates have hit the zero lower bound.

Beyond that, the Fed needs to improve how it communicates about the economic outlook and potential responses to it. The Summary of Economic Projections (SEP), released every other policy meeting, overemphasizes officials' baseline forecasts. From interest rate forecasts, one cannot tell whether disagreement stems from different views of the economic outlook, or from differing opinions about "how the Fed should respond to a particular economic environment." The Fed should not just make marginal adjustments, but should shift to publishing detailed staff forecasts including alternative scenarios. This is the strategy used by the European Central Bank, which also has a large number of members distributed across a wide geographical area.

Given the extreme political pressure exerted by the Trump administration, the Fed may be tempted to adopt a conservative stance and reduce reform efforts—to avoid implicitly admitting that the previous framework was flawed. But that would be a mistake. To maintain independence, the Fed should strive to build a monetary policy framework that is as effective and comprehensive as possible. As the world and the architecture of the financial system evolve, the Fed must also keep pace.

The above views are excerpted from former New York Fed President Bill Dudley.