US Economic Perspectives:Fed policy framework,Is the price(level)right?

In recent weeks, many Fed officials have raised the possibility of reconsideringthe Fed's current policy framework of targeting a 2% inflationrate. This possibility has been mentioned by regional Fed presidentsacross the hawk-dove spectrum, including Mester, Williams, Bostic, andEvans. Tomorrow’s minutes could provide further indications that thisis becoming a lively debate among Fed officials. Given the breadth andincrease in the intensity of this discussion, markets should take note.

    There are several reasons why this debate is heating up. First, there isa growing consensus among Fed officials that r-star is likely to remainlow, increasing the odds of hitting the zero lower bound and reducing thecurrent framework's effectiveness. Second, the turnover in Fed leadershippresents an opening for a serious re-think of its policy framework. Third,the relatively calm economic backdrop is conducive to this debate, anda framework change, if it occurs, would be in place well before thenext downturn. Fourth, the Fed may be constrained in its future use ofextraordinary monetary policy, so a framework that makes it less likely tobe in that situation would improve monetary policy's overall effectiveness.

    We detail various options for new frameworks, focusing on the prosand cons of each, along with market implications. These options includea higher inflation target, price level targeting, nominal GDP targeting,temporary versions of the preceding frameworks, and enhanced forwardguidance when the fed funds rate is at the zero lower bound.

    All of the options have drawbacks and none clearly dominate the currentframework. We view a higher inflation rate target as least likely, and seea bit more merit in a price-level or nominal GDP targeting framework. Ofnote are the temporary versions, which only apply at the effective lowerbound, mitigating the costs that society bears in normal times.

    Given the significant drawbacks to each option, we are unconvincedthat a meaningful market-relevant change will occur. More likely, inertiacould keep the current framework in place with close calls betweenthe alternatives' pros and cons. Unconventional monetary policies thatmitigate the pain of zero lower bound events also reduce the likelihoodof the Fed overhauling its entire framework. We expect that it will takesome time for any conclusion to be reached about how to change theFed’s framework, if at all. Nonetheless, market participants will hear agood deal more about these options over the coming months.