The U.S. Federal Reserve has developed a pretty poor track record for meeting its inflation and employment goals. If it wants to do a better job, it should follow Canada’s example and set some deadlines.
More than four decades ago, Congress mandated that the Fed’s monetary policy pursue two objectives: price stability and maximum employment. In January 2012, the central bank clarified the former by adopting a 2 per cent target for its preferred measure of inflation (the price index for personal consumption expenditures). For more than seven years, it has systematically undershot that goal.
Why the poor performance? One explanation is the lack of a time constraint. The Fed says that it intends to hit 2 per cent only in the longer run — which could mean one year, 10 years or even longer. Officials intentionally leave the period vague, presumably so that they can always claim to be on the path to (eventual!) success. Yet the uncertainty also leaves markets, the public and even policy makers guessing about the role the target plays in the central bank’s regular interest-rate decisions. This undermines its relevance for understanding how inflation will move in the short and medium term.
The time horizon matters even more for employment. Consider what happened in mid-2013, when the Fed triggered a bond market rout by announcing its intention to remove stimulus by cutting back on its securities purchases. This tightening of monetary policy was possible because most (actually 16 out of 19) policy makers agreed that it would be appropriate to allow the unemployment rate to remain elevated for more than 30 months.
Imagine what would have happened if the Fed had faced, say, a 24-month deadline to bring unemployment down to its long-run level. Policy makers couldn’t have started tightening when they did. As a result, households would have expected unemployment to fall more rapidly – and would generally have had more confidence in its propensity to do so in any recession. That confidence would, in and of itself, support demand and lead to a faster recovery.
Now is an opportune time for the Fed to reconsider its time constraints. The central bank happens to be in the middle of an extended review of its long-term policy framework, with an eye toward enhancing its effectiveness in the next recession.
Every CEO knows that goals without deadlines are unlikely to have much effect on decisions or expectations. That’s true about monetary policy, too. The Bank of Canada has adopted a time horizon of 18 to 24 months to fulfil its mandate, allowing for occasional deviations in unusual circumstances. The Fed should do the same.
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