The Federal Reserve's Review of Its Monetary Policy Strategy, Tools, and Communication Practices.

• Author: Clarida, Richard H.

I am delighted to be at the Cato Institute today to participate in your annual monetary conference. The last time I had the privilege of speaking at this conference was in 2004. This year's conference, "Fed Policy: A Shadow Review," takes up the Federal Reserve's 2019 review of our monetary policy strategy, tools, and communication practices. This topic is, of course, timely and one to which I and others have devoted much thought over the past year.

Motivation for the Review

Although I will have more to say about the review in a moment, let me state at the outset that we believe our existing framework, which has been in place since 2012, has served us well and has enabled us to achieve and sustain our statutorily assigned goals of maximum employment and price stability. However, we also believe now is a good time to step back and assess whether, and in what possible ways, we can refine our strategy, tools, and communication practices to achieve and maintain our goals as consistently and robustly as possible. (1)

With the U.S. economy operating at or close to maximum employment and price stability, now is an especially opportune time to conduct this review. The unemployment rate is near a 50-year low, and inflation is running close to our 2 percent objective. With this review, we hope to ensure that we are well positioned to continue to meet our statutory goals in coming years.

The U.S. and foreign economies have changed in some important ways since the Global Financial Crisis. Perhaps most significantly, neutral interest rates appear to have fallen in the United States. (2) A fall in neutral rates increases the likelihood that a central bank's policy rate will hit its effective lower bound (ELB) in future economic downturns. That development, in turn, could make it more difficult during downturns for monetary policy to support spending and employment and to keep inflation from falling too far below the central bank's objective--2 percent in the case of the Federal Reserve. (3)

Another key development in recent decades is that price inflation appears less responsive to resource slack. That is, the short-run price Phillips curve--if not the wage Phillips curve--appears to have flattened, implying a change in the dynamic relationship between inflation and employment. (4) A flatter Phillips curve permits the Federal Reserve to support employment more aggressively during downturns--as was the case during and after the Great Recession--because a sustained inflation breakout is less likely when the Phillips curve is flatter. (5) However, a flatter Phillips curve also increases the cost, in terms of lost economic output, of reversing unwelcome increases in longer-run inflation expectations. Thus, a flatter Phillips curve makes it all the more important that inflation expectations remain anchored at levels consistent with our 2 percent inflation objective. (6) Based on the evidence I have reviewed, I judge that U.S. inflation expectations today do reside at the low end of a range I consider consistent with our price-stability' mandate.

A Robust U.S. Labor Market

For some time now, price stability in the United States has coincided with a historically low unemployment rate. This low unemployment rate, 3.6 percent in October, has been interpreted by many as suggesting that the labor market is currently operating beyond full employment. However, we cannot directly observe the level of the unemployment rate that is consistent with full employment and price stability, [u.sup.*], but must infer it from data via models. I myself believe that the range of plausible estimates of [u.sup.*] extends to 4 percent and below and includes the current unemployment rate of 3.6 percent.

As the unemployment rate has declined in recent years, labor force participation for people in their prime working years has increased significantly, with the October participation rate at a cycle high of 82. 8 percent. (7) Increased prime-age participation has provided employers with additional labor resources and has been one factor, along with a pickup in labor productivity, restraining inflationary pressures. Whether participation will continue to increase in a tight labor market remains to be seen. But I note that male prime-age participation still remains below levels seen in previous business cycle expansions.

Also, although the labor market is robust, there is no evidence that rising wages are putting excessive upward pressure on price inflation. Wages today are increasing broadly in line with productivity growth and underlying inflation. Also of note, and receiving less attention than it deserves, is the material increase in labor's share of national income that has occurred in recent years as the labor market has tightened. As I have written before, labor's share tends to rise as expansions endure and the labor market tightens. (8) In recent cycles--and thus far in this cycle--this rise in labor's share has not put excessive upward pressure on price inflation.

Scope of the Review

The Federal Reserve Act instructs the Fed to conduct monetary policy "so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates." (9) Our review this year takes this statutory mandate as given and also takes as given that inflation at a rate of 2 percent is most consistent over the longer run with the congressional mandate.

Our existing monetary policy strategy is laid out in the Committee's Statement on Longer-Run Goals and Monetary Policy Strategy. (10) First adopted in January 2012, the statement indicates that the Committee seeks to mitigate deviations of inflation from 2 percent and deviations of employment from assessments of its maximum level. In doing so, the Federal Open Market Committee (FOMC) recognizes that these assessments of maximum employment are necessarily uncertain and subject to revision.

As a practical matter, our current strategy shares many elements with the policy framework known as "flexible inflation targeting." (11) However, the Fed's mandate is much more explicit about the role of employment than that of most flexible inflation-targeting central banks, and our statement reflects this by stating that when the two sides of the mandate are in conflict, neither one takes precedence over the other.

The review of our current framework is wide ranging, and we are not prejudging where it will take us, but events of the past decade highlight three broad...