The Federal Reserve Should Do More

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All eyes are on the Fed today, as the Federal Open Market Committee (FOMC) concludes its fifth policy meeting of the year. Expectations are running high for further easing at this meeting to support the anemic economy. Some Fed-watchers expect the FOMC to announce a new asset-purchase program, the most aggressive option on the table.

No matter what the FOMC does, it will be criticized in some quarters. If it chooses not to undertake a new round of asset purchases, commentators on the left again will lambast the Fed for doing too little to bring down unemployment. At the same time, conservative economists have criticized the Fed for venturing too far down the path of unconventional policies, and they fear that the Fed's asset purchases have greatly increased the risk of future inflation. A further expansion of the Fed's balance sheet will only stoke their ire.

I agree with those who say the Fed should do more. The Fed has a dual mandate to promote price stability and full employment. But in responding to the financial crisis, the FOMC has shown little appetite for an amount of stimulus that would push inflation above its target rate of 2 percent, even temporarily. Indeed, Chairman Bernanke has called the idea "reckless". The FOMC has been unwilling to exploit the short-term trade-off between inflation and unemployment permitted by the dual mandate.

The Fed's one-sided implementation of the dual mandate likely reflects two factors. The first is that the Fed does not want to damage its credibility as a low-inflation central bank. All FOMC members, from the Chairman on down, accept this mantra -- understandably so. Second, the Fed worries about threats to its independence, most of which come these days from conservative inflation hawks. The best defense against that threat is to refrain from actions that could raise inflation above target.

There may be a way, however, for the Fed to provide more stimulus without putting its credibility or independence at risk. To see how, let's go back to the FOMC's statement on longer-run goals and strategy that was released with much fanfare in January. The statement established an explicit inflation target; previously, the FOMC had only signaled indirectly its preferred rate of inflation. The statement also explained that the FOMC could not specify a fixed target for the unemployment rate because many factors other than monetary policy influence the labor market; rather, the FOMC would assess what constitutes full employment on an ongoing basis. So far so good.

Unfortunately, the statement is nearly vacuous regarding the strategy to achieve these goals. It says only two things. First, the FOMC will seek to mitigate deviations of inflation and unemployment from their respective goals. This is just a restatement of the dual mandate. Second, when the two objectives pull policy in different directions, (for example, when inflation and unemployment are both higher than desired), the FOMC will follow "a balanced approach" to reduce the deviation of both variables from desired levels. That's the whole discussion of strategy. There is nothing on what the FOMC considers to be an acceptable range for inflation around the 2 percent target, no guidance on the expected timeframe for returning inflation back to target should it move outside the acceptable range, and nothing on how the FOMC will be accountable to Congress for misses on both policy objectives. No wonder the Fed's critics on the right believe that it exercises too much discretion when setting policy and are not confident that it will keep inflation under control.

A beefed-up policy statement would limit the Fed's discretion but also give it more leeway within those bounds to ease policy. To illustrate this point, assume the jobless rate is 8 percent, well above the level believed to be consistent with full employment. Assume as well that inflation is running at 2½ percent -- slightly above the Fed's target -- and that the FOMC projects it to remain there for the next few years. In this scenario, the dual mandate gives the Fed the latitude to ease policy to bring down the unemployment rate, the more serious of the two target misses. However, the Fed's behavior in recent years suggests that it would be hesitant to act.

Now, introduce a revised policy statement that says the FOMC considers inflation between 1 and 3 percent to be an acceptable range around the target. Moreover, if inflation moves outside this range, the revised statement obligates the FOMC to explain how inflation will be brought back to target within a specific timeframe, say one to two years. With this policy statement in place, the FOMC would be free to ease further, provided that it expects inflation to remain below 3 percent after the easing. If this forecast proves to be wrong and inflation rises above 3 percent, the Fed would be on the hook to guide it back to target. This is a win-win compared to the current situation: more aggressive action to combat high unemployment, combined with insurance against runaway inflation.

A strategy statement with more meat than the current one would enable the Fed to pursue its dual mandate in a more balanced way, while committing the Fed to keep inflation in check. Such a statement would advance the Fed's goal of making monetary policy more transparent, more accountable, and more effective.

It will not be easy for the FOMC to craft a strategy statement that moves beyond platitudes. If it were, the FOMC would have succeeded on its first try. However, Chairman Bernanke has said repeatedly that the FOMC is continuing to explore ways to improve its communication about monetary policy. In that vein, the FOMC should take another crack at writing a strategy statement with content. It's worth the effort.


Stephen Oliner is a resident scholar at the American Enterprise Institute and a senior fellow at the UCLA Ziman Center for Real Estate. He was formerly an associate director in the Division of Research and Statistics at the Board of Governors of the Federal Reserve System. 

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