The latest twist in the high drama of monetary policy after the 2008 global financial crash unveiled recently. The Ben Bernanke-led US Federal Reserve committed to buy mortgage-backed securities (MBSs) and longer-term treasuries to “help ensure that inflation, over time, is at the rate most consistent with its dual mandate”. But the more interesting part followed when it committed to keeping the Fed funds rate between zero and 0.25% so long as unemployment doesn’t fall below 6.5% and inflation doesn’t exceed 2.5%. While the dual mandate of Fed has always included inflation and unemployment, this explicit commitment to numerical thresholds on both flanks constitutes a marked evolution of Fed policy. It marks the explicit introduction of the New Keynesian Phillips curve in Fed’s monetary policy framework.
The modern monetary policymaking has its intellectual roots in Milton Friedman’s 1968 presidential address to the American Economic Association. In this speech, Friedman took on the Keynesian Phillips curve and reintroduced the classical notion of a “natural rate of unemployment”. Laid out by the MIT Keynesians Robert Solow and Paul Samuelson in 1960, the Phillips curve demonstrated an empirical regularity between low unemployment and high inflation, and vice-versa, which could in theory be exploited to stabilize the business cycle.
Friedman questioned the notion that such a relationship could be profitably exploited by benevolent policymakers, invoking the argument that there is an unknown, unstable, non-trivial “natural” unemployment in the economy and pushing inflation to reduce unemployment below that only exacerbates inflation further without any corresponding gains in employment.
Friedman’s speech also had a profound, albeit indirect, impact on central bankers, who started talking about monetary policy in terms of inflation expectations and rules. The default position on the formulation of monetary policy changed to the view that it could not reliably target “real” variables such as gross domestic product (GDP) or unemployment—it needed a “nominal” anchor, i.e., something that deals with prices and dollars explicitly. The inflation-targeting regime that subsequently came to dominate monetary policy in developed economies evolved organically from these tenets. This pre-2008 academic and practical consensus on monetary policy was essentially New Keynesian theory infused with dollops of Friedmanite intuition.
The Phillips curve, however, was not critical to the practical implementation of this consensus.
In fact, Fed was rather unique among large central banks in having a mandate that explicitly included a real variable such as unemployment, though it has itself long been accused of being a closet inflation-targeter. The risk of overshooting inflation was too great for conservative central bankers to reliably commit to targeting unemployment. The preferred mode of maintaining trend GDP growth and low unemployment was through keeping capital markets in high spirits—the infamous Alan Greenspan put on equity markets.
The last few years have seen a slow, painful unravelling of the doctrine of inflation targeting. Central bankers, under attack from conservatives for taking historically unprecedented licence with monetary policy, have found their situation more akin to Sisyphus. Barring a secular commodity boom, the larger industrial economies of the world have struggled to meet their inflation targets even with all the efforts that their central banks have undertaken. Fed, under fire from the right for flushing the world with unprecedented liquidity, has also been criticized by the left for letting aggregate demand and inflation fall below long-run trends, thus responding asymmetrically to the threat of inflation versus unemployment.
With all this as background, the two major decisions and communications by Fed in the last couple of months carry significant signals about shifts in monetary policy. First, Fed initiated the third round of quantitative easing, a programme of purchasing MBSs, especially those backed by newly originated mortgages. The logic was explicit in Fed’s release—the board of governors believed that housing had not played its typical role in leading a recovery this time around. The Bernanke-led Fed doubled down on a specific view of the US business cycle; in a world that’s experiencing a secular decline in the rate of business investment, a housing boom is critical to maintaining high GDP growth and low unemployment. In that release, Fed also gave the first clear signals about committing to fight unemployment specifically.
In the latest release, this commitment has been formalized with numerical thresholds. Fed has made it clear that it does not believe it is operating anywhere near the vertical part of the Phillips curve, and has reaffirmed its ambition to exploit the corresponding slack in the economy. On its website, Fed also mentions that its best estimates of the natural rate of unemployment in the US are between 5.2% and 6%, which means that with its own 6.5% threshold, it has a cushion of safety on the conservative side.
What will the long-term effect of such a shift in the framework be? It’s hard to say—we don’t know if Fed is correct in bypassing received wisdom by pursuing an unstable, possibly chimerical, natural rate of unemployment, or if it will even stick to the new framework for too long. But as the pre-eminent force in monetary policy circles, Fed’s shift is bound to widen the intellectual spectrum of central banks around the world.
Ritwik Priya is a London-based consultant.