Fed should review monetary policy framework – Mester

The president of the Federal Reserve Bank of Cleveland has suggested it may be time for the US central bank to review its current monetary policy framework.

Several members of the Federal Open Market Committee had suggested such a review at their last meeting in January, Loretta Mester noted – something “a careful reader” of the minutes might have noticed, she added.

Mester stressed there was nothing “broken” about the Fed’s current monetary policy framework, saying that “the economy has returned to normal and monetary policy, including the policy rate and the balance sheet, is normalising.”

These conditions give the Fed “an opportunity to look at some longer-run issues,” Mester said in a speech on February 23. “This suggests to me that it may be appropriate later this year to begin an assessment of our current monetary policy framework and alternatives.”

Mester outlined a number of potential routes the Fed could take when conducting such a review, although she did not endorse any of them. “I remain open-minded on this,” she said. “At the same time, a change from flexible inflation targeting shouldn’t be decided cavalierly.”

The Fed currently has a dual mandate aimed at promoting maximum job growth and targeting 2% inflation. Among the proposed changes was a higher inflation target.

Mester said a higher inflation target would make it “more likely” that the Fed could avoid the zero lower bound on interest rates when a negative shock hit the US economy. But she wondered whether this would “outweigh the costs of running a higher level of inflation at all times”.

Several questions will need to be answered, she said. “Will it be easy to raise inflation expectations after having successfully anchored them at 2%? Is 4% inflation seen as consistent with price stability?”

Price-level targets

Mester also considered the case for the Fed pursuing what has been dubbed “price-level targeting”.

Price-level targeting would see the central bank target a gradually rising price level, rather than a fixed inflation target. In this framework, a sustained period of below-target inflation would need to be offset by a period of above-target inflation.

“Unlike inflation targeting, which lets bygones be bygones, these level-targeting frameworks make up for past deviations from the path,” Mester said. But she said a lack of international experience with such frameworks made her reluctant commit to such an arrangement.

“There are also credibility issues,” she added. “Is it credible that policymakers will keep interest rates low to make up for past shortfalls even when demand is growing strongly or that they will tighten policy when demand is weak after a supply shock has raised the price level?”

Mester is not the first Fed official to propose such a framework. In an interview with Central Banking in May, the president of the Federal Reserve Bank of San Francisco, John Williams, argued the Fed should examine the possibility of adopting a price level-targeting framework.

Using the Taylor rule and an inflation gap of prevailing inflation minus the target, Williams was able to put in a measure of a price level gap. “So you’re still responding to the economy and keeping a very simple framework,” he told Central Banking.

Williams has also praised the Bank of Canada for conducting a policy review every five years, suggesting the Fed should consider adopting a similar policy.