Richard Clarida on what went wrong

Former Fed vice chair Richard Clarida has a new paper that examines Fed policy during the Covid period. He argues that the mistakes were tactical, not strategic. I believe they were both.

In August 2020, the Fed adopted a policy of “Flexible Average Inflation Targeting” (FAIT).  Clarida argues that the policy regime is sound, but mistakes were made in the process of implementing the policy.

I agree with Clarida on two key points.  First, it is better to target the average inflation rate over several years, and make-up for inflation shortfalls with a subsequent overshoot of inflation.  In addition, it makes sense to look through supply shocks, and focus on maintaining stable growth in aggregate demand. (That’s the flexible part of FAIT.) Here Clarida discusses what went wrong: 

[B]eginning in the summer of 2021, the incoming data began to reveal that the inflation surge was becoming broad based in both goods and labor markets and that, moreover, the balance of risks to the inflation outlook were skewed decidedly to the upside. Certainly by the fall of 2021 , and as is shown in Figures 4 and 5, time series plots of the above mentioned inflation indicators along with many other inflation readings “went parabolic” indicating clearly that, already by that time, the level of nominal aggregate demand in the economy exceeded available aggregate supply forthcoming at the Fed’s 2% inflation target, even though the data then available . . .  indicated that the level of real GDP remained some 2 percentage points below the CBO’s contemporaneous estimate of potential , that the unemployment rate at 5.2 percent remained well above contemporary estimates of NAIRU, and that the prime age labor force participation remained 1.3 percentage points below its pre pandemic peak. Simply put, the Fed in 2021 got aggregate supply wrong, and in so doing, it kept in place an exceptionally accommodative monetary policy longer than it would have it had not overestimated the economy’s potential . . . 

By the time of September 2021 FOMC meeting, standard monetary policy rules, including the “shortfalls” version of the balanced approach Taylor – rule featured in the Fed’s recent Monetary Policy Reports were signaling that liftoff from the ZLB was by then warranted

Thus, under FAIT the Fed should have raised rates in September 2021, instead of waiting until March of 2022.  In Clarida’s view, there was a series of tactical errors, and the basic FAIT approach remains sound:

Thus it was not the goal that inflation average 2 percent over time as was endorsed in the Fed’s August 2020 framework revision that precluded the FOMC in 2021 from lifting off from the ELB and beginning to shrink its balance sheet. It was instead the Committee’s additional commitment to honor its September 2020 threshold guidance as well as its communication that it would follow a ‘taper – hike – shrink’ sequence of policy normalization similar to the practice it implemented following the GFC , in tandem with a reluctance even to commence the taper until a majority of the Committee deemed that “substantial further progress” towards its maximum employment mandate had been achieved, the threshold standard for tapering QE the FOMC had laid out in its December 2020 FOMC statement. Committing – and honoring the commitment – to follow a ‘taper hike shrink’ sequence and to the delay the taper itself until “considerable progress” had been made towards the maximum employment goal were FOMC decisions with regards to how best to execute policy to achieve the Fed’s dual mandate goals of maximum employment and inflation that averaged 2 percent over time, but were not decisions compelled by or nor were they necessary to honor the either the spirit or the letter of the August 2020 Framework Statement. This also applies to the September 2020 threshold guidance on the conditions for lift off: this stronger commitment was consistent with the new framework, but it was not required by it as is evidenced by the fact that the shortfalls version of the balanced approach policy rule did signal lift off before those conditions were met.

Clarida’s correct that tactical errors were made.  The September 2020 threshold guidance was inappropriate, and indeed was based on a Phillips Curve model that was already discredited by the 1970s.  But Clarida underestimates the problems with the underlying FAIT approach.

The basic problem is that the Fed’s FAIT policy is asymmetric.  The Fed commits to make up inflation undershoots with higher future inflation, but there is no similar commitment for inflation overshoots.  Some argue that offsetting an inflation overshoot would be inappropriate, as it would impose pain on the economy.  But that’s the reason for the “flexible” part of FAIT; policymakers look through supply shocks and stabilize aggregate demand.  Indeed, a properly symmetric FAIT would be essentially equivalent to NGDP level targeting.  Inflation could vary a bit over time due to supply shocks, but in the long run would equal the NGDP target growth rate minus the trend rate of RGDP growth.  Thus if the target were 4% NGDP growth and trend RGDP growth were 1.8%, then inflation would average 2.2%. 

If the primary mistakes were tactical, then how does changing the policy regime fix the problem?  It turns out that tactical errors are much less consequential with a symmetric FAIT approach.  If markets knew the Fed was committed to offsetting both demand undershoots and demand overshoots, then market interest rates would have risen in late 2021 to restrain aggregate demand.  Markets would have seen that the Fed was behind the curve—that NGDP growth was quite excessive—and that this meant much tighter money was coming in 2022.  But merely the expectation of future tight money would have been enough to immediately tighten monetary conditions. 

Yes, the Fed held rates at zero for too long during 2021-22.  But the deeper problem was that they failed to commit to a regime of stable growth in NGDP, making up for both undershoots and overshoots.