Did pandemic central banking work? Fed review to eye inflation, jobs tradeoffs

By Howard Schneider

ATLANTA (Reuters) – The U.S. Federal Reserve’s pledge in 2020 to sustain “broad-based and inclusive” employment through loose monetary policy was considered a bold response to the pandemic, putting its muscle behind the idea that low unemployment and low inflation could coexist.

The ensuing inflation surge has put that view under a spotlight, with scrutiny likely to intensify over the next year as Fed officials prepare for a broad policymaking review that Chair Jerome Powell has said will commence in late 2024.

There’s been no suggestion the Fed will drop language added to its policy framework three years ago nodding implicitly to the gains disadvantaged groups get from tight labor markets and showing a willingness to take risks with higher inflation in order to let the jobless rate fall as low as possible.

Noting the unemployment rate gap between Blacks and whites tends to narrow as the job market tightens, the Fed’s strategy does seem on track to produce more equitable outcomes, said Miesha Williams, an associate professor of economics at Spelman College in Atlanta, where Powell is to appear Friday.

“There’s this goal to be inclusive and while it may be new, it is going to take some ironing out,” she said.

But the experience of the last three years already has led some Fed veterans to call for a renewed focus on preempting inflation before it accelerates and others to say it may be time to consider redefining the inflation target itself, all while Powell points to a deep discussion over shaping central bank policy for the post-pandemic world.

After inflation’s breakout and the scramble to contain it, even strong advocates of aggressive Fed attention to joblessness agree changes may be needed so future officials aren’t constrained by the current framework’s commitment to loose policy as prices take off.

In an essay to be published next year shared with Reuters, former Chicago Fed President Charles Evans, who helped lay the groundwork for the current framework, argues the rise of inflation, driven by stronger-than-expected demand and lingering pandemic supply shocks, show the Fed needs “additional guard rails,” perhaps even an inflation “escape threshold” to allow rate hikes to begin regardless of pledges made about employment.

After cutting rates to near zero to combat the fallout from the pandemic, the Fed in September 2020 said it would not raise them until maximum employment was restored and inflation was above 2% – an effort to achieve its 2% target on an average basis over time after a long period of weak price increases.

Central bankers are loathe to break such outright commitments for fear of losing credibility, and the conditions set for a rate hike are widely seen as slowing the Fed’s response as inflation rose throughout 2021: Its first rate hike did not occur until March 2022.

“My guess is they will have discussions about how quickly and abruptly you can shift gears” when unexpected developments spur prices higher, Evans said.

WHAT HAS CHANGED?

Powell recently pointed to some of the complications flagged by Evans, noting pandemic supply shocks seemed long-lived and perhaps require higher interest rates than would usually be the case for something officials expect to adjust on its own.

Fed policy affects consumer and business demand by influencing the cost of credit through interest rate changes, but the economy’s supply side is regarded as mostly self-correcting as businesses adapt output to demand, a principle challenged by lengthy pandemic disruptions.

More broadly, Powell said the next review would have to tackle an even more fundamental question.

The last one was framed around the experience of the 2007-to-2009 financial crisis and recession, the slow recovery that followed, and the years the Fed kept rates pinned near zero with no conventional way to further help the economy.

Hoping to avoid return trips to that “zero lower bound,” the framework shifted to aim for inflation that averaged 2% over time. Periods of high inflation would offset those when inflation was low as occurred between the financial crisis and the pandemic.

Those concerns may not matter anymore if the pandemic has driven inflation and interest rates chronically higher.

“Among the questions we will consider is the degree to which the structural features of the economy that led to low interest rates in the pre-pandemic era will persist,” Powell said last month.

The Fed has not provided further information about the coming review process. The last one included “Fed Listens” events around the country, allowing business owners, workers, elected officials and others to talk about the economy and how monetary policy impacts their lives. A major research conference at the Chicago Fed delved into different policy approaches.

Whatever the process, the circumstances are radically changed: The pandemic era’s rapid growth and high inflation are a near complete opposite of the decade preceding it.

A ‘NOISY MEASURE’

Officials have begun flagging the issues they want to debate.

Cleveland Fed President Loretta Mester said this week she felt the Fed needs to be more explicit about how financial stability factors into policy, and Chicago Fed President Austan Goolsbee said it might be time to consider relaxing an inflation target he feels is too specific for a “noisy” variable.

“My thing about inflation targets is the false sense of precision to say 2%. What about 2.1?” Goolsbee said in September. “Inflation is an extremely noisy measure so I do think we have to think about that.”

Other policymakers have said they’d prefer a range instead of a specific target for similar reasons.

To former Fed Vice Chair Donald Kohn, however, the lesson of the last few years is different and calls for more old-fashioned policymaking.

Speaking at a Boston Fed labor market conference in November, Kohn said the new framework showed the risks of not keeping inflation at bay to begin with.

“Probing” for maximum employment “can’t ignore…inflation risks,” Kohn said, calling for a return to a strategy disavowed in the last review.

“I think preemptive tightening is best-practice central banking, and I hope they return to allowing that.”

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