by Jon Faust

In August 2020, the FOMC adopted revisions to its policy framework that were mainly intended to deal with the problems of chronically low inflation and interest rates.  In the best tradition of Greek tragedy, high inflation almost immediately ensued. While inflation rose above 2 percent in March 2021, it was not until March 2022, with inflation at 7 percent, that the Fed first raised its policy interest rate. Why so slow? Many distinguished critics (e.g. here, here, here) blame the framework revisions for the delayed response. This critique was well-represented at last week’s Fed conference held as part of a 5-year review of its policy framework and communications.

I was senior special advisor to Fed Chair Powell for six years including the period in question, and I think this critique is wrong. While it provides a tidy excuse, satisfying any urge to find an easy remedy, it does not fit the messy facts as I saw them.  Indeed, encouraging the Fed to conclude that “the framework made me do it” diverts attention from more important questions that this vexing episode raises for the Fed and the macroeconomics profession.

While the critics disagree a bit on how the revisions caused the delay, they all agree that somehow the revised framework had the effect of ruling out preemptive, forward-looking policy to stem incipient inflation.   This argument is problematic in several ways. 

First, the framework puts forward looking policy, including the implications for the balance of risks, at the center of policy: “Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks…”

Second, the framework revision stated that the FOMC would focus on shortfalls of unemployment from its maximum level rather than deviations of from that level.  While this change may seem somewhat obscure, one thing is clear: it did not forbid a forward-looking approach to labor market-induced inflation.  As Powell explained in introducing the revisions:

[T]he change to “shortfalls” clarifies that, going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals. (emphasis added)

Third, blaming the delayed inflation response on a failure to be forward looking actually gets things exactly backwards.  A failure to act on forecasts was not the problem: the problem was taking (erroneous) forecasts too seriously. The Fed famously did not act sooner because it forecast that the inflation would prove transitory, dissipating of its own accord before policy actions could have a beneficial effect.  The episode is a cautionary tale about forward-looking policy, not an argument for it.

Another thread of the critique is that the FOMC’s self-imposed limits on raising rates forced the delay. The FOMC’s forward guidance stated that liftoff would be delayed until both inflation and employment goals had been reached.  When inflation flared before the employment goal had been reached, the argument goes, the Fed was handcuffed.     

Critics argue that the delay could have been avoided if the FOMC had only stress tested the guidance under alternative scenarios.  Without revealing FOMC secrets, however, I can report the obvious:  policymakers were well aware of the possibility that inflation could get out of control before the employment goal had been achieved.  This is why they included an escape clause robust enough to pass any stress test: “The Committee would be prepared to adjust the stance of monetary policy as appropriate if risks emerge that could impede the attainment of the Committee’s goals.” Powell called out this escape clause when the guidance was issued, and the FOMC discussed using it in December 2021.

Powell also stated a willingness to abandon the gradual pace of asset purchase tapering if conditions warranted. For example, asked how the FOMC would react to the possible need to lift off before the planned completion of purchases, Powell responded that the FOMC was not facing this case but “you would stop the taper potentially sooner.”

I am sure there was some reticence to use the escape clause or further speed the taper.  But did this reticence really cause the FOMC to sit on its hands for several months, despite clear signs of what was to come?

No.  The record is clear that the FOMC did not act more aggressively sooner because it judged that the outlook, especially including the balance of risks, did not warrant it. As of September 2021, the median FOMC participant projected that a single 25 basis point rise in the federal funds rate in all of 2022 would be appropriate and would result in a 2022 inflation rate of 2.2 percent. As of December, the median FOMC participant that saw the policy rate rising to less than 1 percent in 2022 and remaining well below the neutral rate (as proxied by the SEP’s longer-run normal value) through 2024.  The vast majority of private sector forecasts were similarly sanguine.

But these overly optimistic forecasts tell only a small part of the story.  The FOMC was acutely aware that any forecast at this time rested on thin ice, and that policy required challenging risk management judgments. 

In Jackson Hole in August, Powell laid out the FOMC’s approach. In essence, the FOMC was weighing the risk of a problematic inflation on one side against the risk of tightening policy prematurely and crippling the recovery on the other. With the benefit of hindsight, it may be difficult to remember that as late as December the recovery was viewed as fragile and vulnerable to emerging virus variants. Moreover, employment remained more than 2 million below its pre-pandemic level.

“The framework made me do it” might be a painful excuse for the FOMC, but it would be a tidy one, side-stepping more difficult questions for the Fed and macroeconomics profession.  Why were the inflation forecasts of the Fed and vast majority of other forecasters so far wrong?   Given the uncertainty of those forecasts, were the Fed’s risk management judgments reasonable? 

Specifically, did the FOMC underestimate the strength of the recovery and thereby worry too much about crippling the recovery?  The FOMC clearly saw a serious upside risk of inflation.  In hindsight, however, the FOMC and the vast majority of analysts seem to have severely underestimated the risk of the virulent burst of inflation that transpired.  Had the FOMC placed more weight on intense inflation scenarios, would policy have been different? Why was this risk underappreciated?

As a participant in the policy process during this period, I have (probably predicable) views about the real-time soundness of the risk management calculus during this episode.  But I will spare you those.  I believe, however, that when the history of this episode is ultimately settled, “the framework made them do it” will garner little more than a footnote, and that the FOMC’s risk management judgments in a murky time will be the main focus.