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Roula Khalaf, Editor of the FT, selects her favourite stories in this weekly newsletter.
The writer is senior strategist at Hudson Bay Capital and former chairman of the Council of Economic Advisers and was a member of the Federal Reserve Board of Governors
Kevin Warsh’s impressive first press conference last week as chairman of the Federal Reserve foreshadowed significant reforms at the US central bank. He announced a series of task forces to overhaul communications, balance sheet policy, data uses and methods, supply-side analysis and the overall inflation framework.
While all these issues are important, two in particular get to the very heart of how monetary policy functions. The inflation framework determines what the Fed pursues in fulfilment of its statutory mandates, and the balance sheet framework determines how the central bank pursues it through setting interest rates and the quantity of money in the economy.
One clue as to what might be coming on the inflation framework is the use of the phrase “price stability” in the policy statement. This evokes Warsh’s mentor, the late and masterful Alan Greenspan, and his predecessor Paul Volcker, who explicitly contrasted price stability with a formal inflation target. Greenspan preferred price stability to a single numerical inflation target because “it has become increasingly difficult to pin down the notion of what constitutes a stable general price level . . . A specific numerical inflation target would represent an unhelpful and false precision.” For Volcker, price stability was “a situation in which expectations of generally rising prices over a considerable period are not a pervasive influence on economic and financial behaviour”.
The distinction matters because measuring inflation, or the change in the general price level, is extremely difficult. The general price level doesn’t exist, as a barrel of oil exists; it’s an abstraction constructed through a thousand methodological choices, and statisticians face questions that lack any obviously correct answer. How should we measure housing inflation for homeowners? We do it one way in the US, and it’s a good way, but not the only way. In Europe, the member states of the Eurozone couldn’t agree on a common methodology, so they just left it out of their measures altogether.
Given the impossibility of precision in inflation measurement and the variety of inflation measures, a precise target focused on one specific inflation metric is conceptually bizarre. The Fed’s treatment of its employment mandate makes more sense: it insists the unemployment rate is the single most important measure of the labour market but looks at a whole constellation of data.
Indeed, overcompensating for modest shortfalls of measured inflation relative to its target before the pandemic led the Fed to pursue above-target inflation through its ill-fated “Flexible Average Inflation Targeting”. This quickly metastasised into the worst inflation shock in 40 years, an outcome price stability would have averted. Abandoning the precise inflation target and making a full return to price stability would be a wise choice — but only once the target has been achieved, to avoid the impression of moving the goalposts.
The prospect for balance sheet reform under Warsh is exciting as well, since it will help determine how the Fed achieves its goals. The Fed’s current approach to its balance sheet has a number of notable drawbacks: it involves the bank in fiscal and credit decisions, thereby weakening its monetary independence; it disintermediates financial markets as the Fed becomes the default counterparty for certain transactions; it limits policy space for future balance sheet expansions should they ever become necessary again, say in a systemic banking crisis; and it can create material financial losses for the central bank.
Fortunately, reducing the Fed’s balance sheet is an attainable goal. In work earlier this year with Federal Reserve colleagues Alyssa Anderson, Alessandro Barbarino and Anthony Diercks, I outlined options for reducing the balance sheet by $1tn-$2tn. The key is to take steps to reduce demand for central bank reserves; this turns the usual model on its head, in which the Fed takes reserve demand as given and adjusts supply.
Among other things, the Fed should make it easier for banks to put discount window access towards their liquidity requirements, destigmatise discount window and intraday credit use, and tweak the relative levels of its various implementation rates. But any start to balance sheet reduction has to proceed carefully to avoid overwhelming markets with more securities than they can absorb.
The good news is that it’s doable, and a smaller Fed will mean a healthier economy. The future of monetary policy is bright.
