The Federal Reserve is considering a changing its monetary policy framework from flexible inflation forecast targeting to one of several strategies known as make-up strategies.
What does this potentially mean for markets and the economy? I delve into the potential impact in this post, the final in a series of blog posts on the Fed’s potential shift. See my earlier posts on the reasons for this review and what options the Fed is considering.
A few common themes emerge when comparing the efficacy of the Fed’s current monetary policy system with the potential of the make-up strategy alternatives under consideration, including average inflation targeting (AIT) and price level targeting (PLT). Extensive studies on this topic have been done by the Fed and academics outside of the central banking world. Thousands of model outcomes can be summarized into four main features of make-up strategies.
- The economy returns more quickly to a steady state (where inflation is at target and the output gap is closed) after a downturn.
- Interest rates would likely stay lower for longer. If the Fed had adopted any one of a number of make-up strategies after the global financial crisis, it would probably not have started to raise rates from post-crisis lows – even by now.
- Macroeconomic volatility could decrease.
- Asset bubbles could become more common – unless macro prudential rules are tightened when make-up strategies are in place.
See the table below for a more detailed look at how financial markets could respond to three potential scenarios.
Sources: BlackRock Investment Institute, June 2019. Notes: This table shows our assessment of how financial markets may respond to the implementation of a new Fed policy framework if the framework is perceived to be credible. PLT refers to price level targeting. AIT refers to average inflation targeting. Forward-looking estimates may not come to pass.
The current U.S. expansion could have years more to run if a new strategy were implemented. This is because the willingness to consider make-up strategies suggests lower-for longer interest rates and therefore a bias toward easier rather than tighter monetary policy – and a lower chance that a policy mistake could cut short the expansion. But other potential risks to the recovery would need be monitored closely because financial vulnerabilities would likely build up faster.
If the Fed decides that a make-up strategy should be implemented, we believe that the future chance of extreme macro outcomes – especially a recession deepening into a full-blown depression because of a lack of monetary policy firepower – may be reduced. This is because the interest-rate floor may not become a limiting factor as often. The risk of full-blown deflation would also decline, in our view. The lower chance of these negative events – combined with lower-for-longer interest rates and higher long-term inflation expectations – would likely support risk assets.
Volatility – currently low by historical standards – could also change. Medium-term macroeconomic volatility would likely decline under credible make-up strategies. Volatility could also rise in the short term while the market digests any new Fed inflation strategy. Effective Fed communication would be needed to manage this transition.
But in reality, any actual implementation of AIT (or other make-up strategies) is likely to be diluted. As the Fed’s Richard Clarida said in May this year, “our review is more likely to produce evolution, not a revolution, in the way we conduct monetary policy.” The more central bankers say there won’t be a big change, the lesser the likely impact.
Policymakers may only introduce a new strategy during the next downturn. They may also be wary of financial overheating and the resulting risks to financial stability. Importantly, AIT depends on the successful manipulation of inflation expectations, something central bankers have been unable to effectively do during this economic recovery. Some of the make-up strategies being proposed – such as “temporary” or “targeted” PLT – could suffer from time inconsistency issues relating to the challenge of central banks to pre-commit to a specific policy promise. A final consideration: AIT would be undermined if it were implemented without specifying the steps that would be taken to bring about inflation overshoots.
Our bottom line
The actual impact of a change in the Fed’s monetary policy playbook may only be a shadow of what AIT and other make-up strategies promise on paper – unless the change in the strategy comes with an upward adjustment to the inflation target itself.