EVAN HOROWITZ | QUICK STUDY
2013 Globe file photo
The Federal Reserve’s mission is to steer the economy through tumultuous waters with a steady hand. But that may get harder in 2018, because the Fed is becoming increasingly short-handed — and the guiding stars are getting dimmer.
An exodus of experienced members, combined with a growing crisis of confidence in the traditional tools of economic management, are transforming the Fed. The effect could be an unpredictable reshaping of this august body, whose impact on the US economy is unmatched.
Let’s start with the problems of personnel. At full strength, the Federal Reserve has seven board members. Soon, it will be down to just three — once President Trump’s pick for the next chairman, Jerome Powell, gets confirmed by the Senate.
This creates a rare opportunity for Trump, who could fill four additional open seats with favored candidates and potentially reorient monetary policy for the next decade.
Trouble is, the appointment process can be very slow, as Trump is learning — weeks have ticked by since he nominated Powell in early November.
In the meantime, recent departures have left the Fed unusually short on academic experts. Outgoing chair Janet Yellen is a widely respected researcher in macroeconomics, as was her recently retired vice chair, Stanley Fischer. Powell comes from a different world, bridging law and finance. And among the other board members, only one has graduate training in economics.
Now, there’s more to the Fed than the remaining three members (and four unfilled seats.) The twelve presidents of the regional Fed banks also participate in official meetings and get occasional, rotating votes. But here too there’s an unusual amount of instability, including the fact that the lone Fed president with a permanent voting position — the head of the New York Fed — recently announced that he also is stepping down.
More than that, the regional presidents sticking around are doing their part to shake up the Federal Reserve, including by pushing for a reevaluation of its approach to managing the economy.
Take Boston’s own Fed president, Eric Rosengren, a 10-year veteran with a reputation for updating his views to match changing evidence.
During a talk earlier this month, Rosengren said that his thoughts were once again “evolving” — and then he mooted a new approach for managing the economy and called for “comprehensive reconsideration of the monetary policy framework.”
The reason? Inflation. That’s been one of the great puzzles of recent years. Even as America’s unemployment rate has dropped to near-historic lows — besting even the most optimistic estimates from the Fed — inflation has remained stubbornly low. Not once in the last five years has the nation’s inflation rate hit the Fed’s 2 percent target. That’s especially notable because that target is supposed to be symmetric, meaning that inflation should be above 2 percent just as often as it is below.
Rosengren isn’t overly worried about the short-term implications of low inflation. He argues, as he has for some time, that the Fed will soon hit its 2 percent target.
But he is concerned about the long-term implications, on the grounds that low inflation could make it harder for the Fed to fight future recessions.
When it comes to fending off recessions, what really matters isn’t just the Fed’s headline interest rate — it's the combination of rates and inflation. The same interest rate, say 1 percent, can provide different amounts of stimulus, depending on inflation. All else being equal, higher inflation means more stimulus at a given interest rate.
Rosengren worries that with a 2 percent inflation target, the Fed could cut interest rates to zero in the next recession and still not provide enough stimulus. But if inflation were higher, those near-zero rates would be more potent.
To accomplish this, he suggests that the Fed embrace a range of acceptable inflation rates, rather than a specific target. To begin, the Fed could announce its long-term intention to maintain an inflation rate between 1.5 and 3 percent, for example. Then, over time, it could pick more precise targets — from within that range — as circumstances required.
If that sounds dangerously loosey-goosey, remember that the Fed is less exacting when it comes to the other half of its dual-mandate: keeping unemployment low. There is no unemployment target — nothing to suggest that 4 percent unemployment is the right amount, or 4.5. Instead, the Fed is constantly adjusting its estimate of the ideal unemployment rate based on incoming evidence and future expectations.
And Rosengren isn’t the only one reaching for new approaches. His colleague at the San Francisco Federal Reserve, John Williams, has called for replacing the inflation target with a separate mechanism that would encourage the Fed to balance periods of lower-than-expected inflation with equal periods of higher-than-normal inflation. A variant of this approach has even been embraced by none other than the original architect of the 2 percent target, former Fed chair Ben Bernanke.
Not everyone at the Fed is equally enthusiastic about such changes, which only intensifies the challenge for a body that prides itself on consensus-based decision-making.
Put it all together and 2018 could prove a pivotal year in the history of the Federal Reserve — new leadership, empty chairs, fresh faces, fewer academics, and a widening call to reconsider governing principles.
Actually, there’s one more thing: an economy that’s about to get a major hit of stimulus from fast-acting corporate tax cuts. Whether that translates into real gains for workers or drives the economy into the red zone will depend in part on how the new Fed chooses to respond.
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