Mickey Levy on How to Reboot Fed Policy Ahead of its Upcoming Framework Review

Mickey Levy is Chief Economist for the Americas and Asia for Berenberg Capital Markets, a Wall Street veteran, and a longstanding member of the Shadow Open Market Committee. He and his co-author, Charles Plosser, also have a new paper out titled, *The Fed’s Strategic Approach to Monetary Policy Needs a Reboot.* Mickey joins David on Macro Musings to discuss this paper and its implications for the upcoming Federal Reserve framework review. David and Mickey also discuss the impact and importance of a flat Phillips curve, the Fed’s policy mistakes in the wake of its new flexible average inflation targeting (FAIT) framework, recommendations for how the central bank should approach the next framework review, and much more.

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Read the full episode transcript:

Note: While transcripts are lightly edited, they are not rigorously proofed for accuracy. If you notice an error, please reach out to [email protected].

David Beckworth:  Mickey, welcome to the show.

Mickey Levy: It's a pleasure to be here.

Beckworth: It's great to have you on, and I have gotten to know you through the years at the Hoover Monetary Policy Conferences, and I believe also at some Cato Monetary Policy Conferences. In fact, I was thinking, Mickey, probably the first time, I think, I had a long conversation with you, we were in a taxi returning from a Hoover Monetary Policy Conference to the airport. You were in there, and Charlie Plosser, your co-author of this paper that we're going to talk about, was in there.

Beckworth: I remember, I was trying to really make the case for NGDP targeting to Charlie. He was skeptical about the idea, but you were embracing it. It took Charlie a bit more convincing before he warmed up to the idea, but that was the first time, I think, that we had a meaningful conversation. Since then, I've continued to see you at the conferences. I'm excited to go over this paper that you just presented at the most recent Hoover Monetary Policy Conference. Before we do that, let's talk about you. Tell us about yourself. How did you get into this career path? What is your journey?

Mickey Levy’s Career Path and Takeaways from the Most Recent Hoover Monetary Policy Conference

Levy: My journey is that I've spent a career analyzing fiscal and monetary policies, but not just theoretical and academic, but also from within financial markets; how fiscal and monetary policies affect economic and financial market behavior. I've thoroughly enjoyed this, and over the decades and generations, I've been able to see how the debate has evolved. Of course, what's so interesting now is that monetary policymakers thought they had learned so much from the 1970s, but then they fell into a bad way, and we came up with their worst behavior and the highest inflation in 40 years with the recent high inflation. So, It's all very, very interesting, what's going on now.

Levy: Once again, the paper that Charlie and I wrote is really geared toward the Fed's upcoming strategic review. And what we try to do in this paper is analyze the evolution from their 2012 strategic plan, their original plan, to what led to its strategic plan that they rolled out in August of 2020, how it performed, and then we try to provide them advice and suggestions for how they should conduct their upcoming review. It was a fun project, and of course, working with Charlie Plosser was absolutely educational for me.

Beckworth: So, Mickey, I missed your presentation at the Hoover Monetary Policy Conference, but I watched it later, and you were part of a very interesting panel that looked at the upcoming review. There was you and Charlie, and then also Athanasios Orphanides, and you guys had a similar pitch. You saw some serious problems, but you wanted to fix it. You wanted to make it better. So, you're kind of salvaging the Fed's framework and putting it in a more productive discussion.

Beckworth: You also had Jon Steinsson. He was much more sympathetic. He wanted a few tweaks. He's much more sympathetic, I think, to FAIT. He saw it as a version of, maybe, Milton Friedman's plucking model. But at the other extreme, we had Larry Summers, who wanted to completely ditch the 2% inflation target altogether, have a whole lot more humility. What was your takeaway from that panel before we jump into your paper? Because that was a very interesting and diverse view of points about the upcoming framework review.

Levy: It was a diverse panel. Plosser and I and Athanasios were critical of the Fed's strategy and performance. I was kind of surprised by Steinsson, who basically said, "Well, the higher inflation is largely due to supply shocks, and the Fed had this decision when inflation rose, whether to reduce services prices, to offset the higher goods prices.” I was scratching my head saying that, to me, that didn't make much sense. Then, Summers stepped in, and I applaud Summers for being one of the few, very few economists prominent in the Democratic Party who have come out and been critical of the Fed and the Biden administration. And he really blasted the Fed. I disagree with him. I think it is very important for the Fed to target a low inflation number. I think it's critically important, in part, to anchor inflationary expectations, but it was really a free-for-all.

Levy: What was interesting is that in the panel that followed ours, the last panel of the day at the Hoover Conference that involved policymakers, Austan Goolsbee, who's president of the Federal Reserve Bank of Chicago, actually referred to my paper with Plosser saying that the Fed is going to be open to maybe modifying its Summary of Economic Projections. Maybe there is some possibility that the Fed is asking itself, how can we undertake a strategic review without completely acknowledging that the past strategy was wrong? So, maybe there's a foot in the door. Maybe we could get an honest, evenhanded review out of the Fed.

Beckworth: I think we can. I recently chatted with Mary Daly on the podcast and she said, "Look, going into this review, I think an important question is that we need to reconsider whether we're going to be coming from below the target or from above the target." She said, "Nowadays, it's not clear, the old assumption of coming from below the target holds. So, we need to reconsider that point." So, I think they're open-minded and they're willing to consider things.

Beckworth: Let's go ahead and jump into your paper. Again, the title of your paper with Charlie Plosser is, *The Fed's Strategic Approach to Monetary Policy Needs a Reboot.* The first part of your paper goes through the history, the evolution of monetary policy at the Fed prior to 2019, 2020. They had several meetings where they made this decision to switch over, but prior to that, there's a context, a historical context. Walk us through that. What was happening that helped shape that first framework review?

What Shaped the First Fed Framework Review?

Levy: That is one of the critical points we make in this paper, and that is, following the financial crisis, the economic recovery from the crisis was weak. Inflation stayed low, and in 2012, the Fed implemented its first strategic plan after a long internal debate. And I might note that Charlie Plosser, then president of the Federal Reserve Bank of Philadelphia, was one of the key drivers and co-authors of that. What it did is it implemented— basically, it had several key components.

Levy: One, it established, for the first time ever, a target for inflation of 2% based on the on the PCE price index. Secondly, it specifically said that it was not going to set a numeric goal for employment, because employment is generated by a lot of non-monetary factors; education skills, regulations, taxes, et cetera, et cetera, in addition to monetary policy. So, it’s dual mandate— it said maximum employment, without putting a numeric target on it, and 2% inflation.

Levy: What then followed is very interesting, because it was a very long expansion where the unemployment rate came down to 3.5%, the lowest rate in 50 years. It was a gradual growth. Early on in the expansion, the Fed was very concerned that the unemployment rate had stayed so high following the financial crisis. So, that was the Fed's earlier concern, but then inflation stayed low, and the Fed, even though the economy was doing just fine— and inflation, actually, fell sharply with the plummeting oil prices in 2014 and '15. Headline inflation came down towards zero, but following that, inflation came back up to close to 2%.

Levy: But the Fed, by that time, had tremendous concerns that if inflation stayed below 2%, that inflationary expectations could plummet, which would, combined with Fed estimates that the natural rate of interest was in a secular decline, would lead to the Fed facing the zero or effective lower bound that would constrain its conduct of monetary policy, should there be another economic downturn.

Levy: So, this backdrop, David, is very important, because it skewed the Fed's strategic review that it undertook in 2019, and it actually predetermined what not just the strategic review would review, but it predetermined the outcome of the new strategic framework. And it wasn't an even-handed review, it was all about the Fed's fears of inflation being too low relative to its 2% [target] and the risk of inflationary expectations falling in the zero lower bound. This drove the review, and so, after a year of review, geared toward this fear of the zero lower bound, the outcome was predetermined, the new strategy.

Beckworth: We'll come back to this point a little bit later, but it's a key point, that the framework review was centered around one set of problems, and it ignored all of the other potential problems that we then experienced in the pandemic; high inflation, how to deal with high inflation. It wasn't very robust to different shocks is maybe another way of saying that. But just to go back a minute, you mentioned that 2012 was a pivotal time. The Fed officially adopts an inflation target. Some would argue that it unofficially had something closer to two before then. What about the 2016 change? In 2016, they added the term “symmetric” inflation into that statement. Was that consequential? Did that matter that? Was that useful? What do you think?

The Fed’s Addition of “Symmetric” Inflation

Levy: Okay, so, before you get to 2016, what's interesting is the— Okay, so the Fed, in January of 2012, adopts its first ever strategic plan. They call it the consensus statement that emphasized the 2% inflation [target] and maximum employment, even though they couldn't quantify it. But the Fed, at that time, was very, very concerned about the slow recovery. They had forecast that with keeping rates at zero and [with] their QE1 and QE2 and President Obama's— it was called the American Recovery and Reinvestment Act, would have stimulated much stronger growth and higher inflation, but that didn't occur.

Levy: And so, within months after the approval of that strategic review in 2012, then Fed Chair Bernanke laid out a justification for QE3, even though the economy was growing. So, he basically used what had been an unconventional monetary policy that is quantitative easing and transformed it to use it during an economic expansion, with the sole purpose of trying to stimulate more growth and more employment and a lower unemployment rate.

Levy: Then, fast forward to mid-2014, and you had oil prices fall by over 50%, and headline inflation plummets towards zero, and the Fed is very concerned, and inflationary expectations, by market-based surveys, it does come down. Even though it proved to be transitory, the Fed was very concerned, so then they tweaked the consensus statement to say symmetric, but clearly, they're looking up at 2%, and they would have been more comfortable with inflation being 2%.

Levy: Now, what's interesting is that after that— and many people don't acknowledge this— that once the transitory effect of the plummeting oil prices ran their course, in the four years, 2016 to 2019, the CPI was exactly 2%. The PCE inflation averaged 1.6, so there was a gap. And during that period, David, the Fed continued to project, in its SEPs, that inflation would rise to 2%, and market-based measures of inflationary expectations and survey-based methods were pretty closely anchored to 2%. Yet, the Fed just had this real fear of collapsing inflationary expectations in the zero lower bound, and this fear was built into their specific models to accentuate these fears.

Beckworth: So, to be charitable to the Fed here, let's maybe go back to the late 1990s when a lot of people were worried about Japan. They had deflation, so people were talking back then about the zero lower bound. Then, post-2008, it seems to be a problem in the US. So, again, it becomes a big issue. So, it's on everyone's radar, and they're thinking about this drift down in inflation expectations like you mentioned.

Beckworth: Now, you mentioned that the PCE [was] really 40-50 basis points below target for most of this period between 2019 and after the great financial crisis, which doesn't seem like a lot, but I could imagine someone from the Fed saying, "Sure, that's not a big margin," but over time, the price level is drifting down. The compounding effect of every period, just a little bit, means this big divergence between where we implicitly said the price level would be versus where it ends up.

Beckworth: Now, that would be one story. You could come back and say, "Well, really, those 40-50 basis points, that's just noise, it's mismeasurement. We're pretty close, anyways, to where we would have been. Households aren't noticing the difference in this price level drift.” But how would you respond to someone who would say, "Well, what about price level drift over the decade?”

Price Level Drift, Deflationary Fears, and Inflation Expectations at the Fed

Levy: Fair enough. Basically, the 2% target date that the Fed settled on in 2012 basically let bygones be bygones, that if you had inflation coming in a couple tenths below, you still aim for 2%. But the key point is, all monetary economists agree in the importance of anchoring inflationary expectations low, and this stemmed from the Volcker-Greenspan eras. When we go back to the 2% target that they chose in 2012, the Fed did consider a range, because they know that there's noise in the numbers. But they settled on 2% because a single target would be easier to communicate and convey as their commitment to inflation. Why 2%? Well, they just settled on it because other central banks had that as a target, and 2% was close enough to zero that they could call it price stability.

Levy: The Fed really had this built-in fear, and the fear really began— as you pointed out, Japan had, in the 1990s after their bubble burst, they had on and off bouts with mild deflation, and even though expectations were never toward deflation that led Japanese consumers to save rather than spend, the Fed did have this fear. And in the early 2000s, the Fed was very concerned about a Japan-style deflation taking hold in the US. Then, inflation rose before the financial crisis, when the Fed kept rates low and you had the debt financed housing bubble. 

Levy: Then, the financial crisis hits, and following the financial crisis, that's when all of the Fed's efforts to stimulate the economy didn't work, and you didn't get aggregate demand strong enough on a sustained basis to push up inflation. So, the Fed did have this fear of a Japan-style deflation, and then, as I noted earlier, at the same time, the real, or the natural rate of interest, was declining, and research conducted within the Fed estimated that so-called R-star, the natural rate of interest in real terms, had diminished quite a bit. So, the confluence of that plus the inflation being below their target led them to really fear the effective lower bound.

Beckworth: You mentioned the early-2000 fears about deflation, and that is a great example, to me, of why inflation targeting can sometimes lead policymakers astray, because I know that they were concerned about Japan, and we had just come out of that early 2001 recession, but productivity growth was really robust in 2003-2004. And I think some of that disinflationary pressure could be attributed to that, and had they instead focused more on nominal GDP, total aggregate demand, you would get a different picture. It was relatively stable, robust. Inflation was coming down. I know they were worried about it. And this is something we'll come back to later, but maybe cross-checking themselves on some measure like nominal GDP, final sales, something on the aggregate demand measure, might have helped them there. But going back to the review of the Fed's framework—

Levy: Before going on, we can come back to it but, of course, I'm agreeing with you that— I remember then Fed Chair Greenspan having this real fear of deflation, and there was no reason to have that fear except for, following 9/11 and the recession of 2001, inflation stayed low, but the characteristics and fundamentals of the US economy were so much different than Japan. The Fed, I think, used bad judgment in not looking at the fundamentals that you and I look at that led it to have excessive fears about deflation.

Levy: But David, bringing it back to the Fed's strategic review in 2019 and its new strategic framework in 2020, it's very odd that the Fed, at the time, as during that decade, put a higher and higher emphasis on its ability to manage inflationary expectations. And it felt very comfortable with that ability to manage inflationary expectations. If, in fact, it had that perception that it could manage inflationary expectations, why was it so concerned that inflationary expectations might collapse?

Levy: So, once again, in the economy in 2018-19, you had the unemployment rate at 3.5%, a 50-year low. Inflation is an innocuous 1.6 or 1.7 on the PCE and 2.0 on the CPI. Different measures of inflationary expectations were well-anchored, and the Fed was touting its ability to manage inflationary expectations through forward guidance. Why was it so concerned about a collapse in inflationary expectations that would put it face-to-face with the effective lower bound?

Beckworth: What is your answer for that question?

Levy: I think that it's an inconsistency in the Fed's thinking. I think that it showed this asymmetric worry, and that asymmetric worry became the foundation for their new strategic plan that had asymmetries written all over it.

Beckworth: So, related to that point is an issue that you bring up in your paper, and that is the Phillips curve. So, in that decade leading up to the review, there was a growing consensus that the Phillips curve was flat, at least the term in front of the output gap part of the Phillips curve was flat. How consequential was that to these considerations?

The Impact and Importance of a Flat Phillips Curve

Levy: It was very, very important. So, if we think of the Fed's big macro model and it's thinking about how the economy works, it's basically a neo-Keynesian model infused with inflationary expectations, which centered around an operable Phillips curve. As I've noted, following the financial crisis, the Fed had forecast that its zero interest rates and QEs plus fiscal stimulus would have led to strong growth. When growth did not respond and inflation stayed low, the Fed basically explained the low inflation saying, "Well, the Phillips curve was flatter than we had earlier presumed."

Levy: And that continued, that throughout the post-financial crisis expansion, as the unemployment rate receded, but wages, wage gains, and inflation stayed low, the Fed continued to say that the Phillips curve was flatter and flatter to the point where, in 2019, the Fed— and when I say the Fed, Chair Powell and all Fed members— basically said, "The Phillips curve is flat, and we can't really use it as a reliable predictor of inflation." The importance of this was how it added asymmetric language to its new strategic plan and how it interpreted, or how it would interpret, its maximum employment mandate.

Levy: So, the Fed used— before that strategic plan in 2020, it talked about how it would respond to deviations from maximum employment. Then, along comes the new strategic plan, and they changed the terms to say, "We will focus on shortfalls from maximum inclusive employment." Alongside that, we put that together with the Fed's notion that the Phillips curve is flat and it basically says, "We can have sustained low unemployment with stable low inflation."

Levy: That is, the Fed came to the conclusion that there's no more need for preemptive monetary tightening, which seemed, at the time, very, very risky; a very risky strategy when it had always used preemptive tightening as a critical element in its strategy for controlling inflationary expectations. And it also seemed very, very risky insofar as it realized that the Phillips curve was no longer a reliable predictor of inflation.

Beckworth: Let's talk about the elements of FAIT, the new framework. You already touched on one, the employment side. So, on the employment side, as you noted, there's the new language of shortfalls versus deviations on both sides, plus the term “maximum inclusive employment.” So, it's inclusive employment. It's also shortfalls, not deviations. Then, the other piece of FAIT, of course, is the asymmetric make-up policy. So, the Fed will make up for persistent undershoots to 2%, but above 2%, it falls back to the regular “bygones are bygones” type of inflation targeting practice. Let me go first to the inclusive maximum employment. How consequential was including that term “inclusive”? Is that a big deal or not?

Breaking Down the Elements of FAIT and the Fed’s Policy Mistakes

Levy: In practice, it wasn't that big of a deal. In concept, it was, because they included, almost as a political hand to Congress, that we not only care about maximizing employment, [but] we want our goal to be inclusive. And of course, in an efficient economy, we all wish that there [was] maximum inclusive employment. However, when you dig down and think about it, is the Fed promising things that it's not capable of achieving? And the Fed has always been very careful to say that employment is driven by a lot of non-monetary factors. 

Levy: So, here, one of its employment mandates— the inflation mandate is within the Fed's control. The employment mandate, it's hanging its hat, it's expanding and enhancing it when it knows that it's beyond its control. This could come back and haunt the Fed in the political context. Even from an economics point of view, if you really dug into it and said, "Okay, if you want to maximize employment and make it an inclusive objective, then what does that mean for median wages? And it could be inflationary." But, I think, for practical purposes, it was more of a political statement.

Beckworth: That was my impression, too. Yes.

Levy: And in reality, I think the point was that the Fed was most concerned that inflation was too low, and that there might be a fall in inflationary expectations. They came to believe that the Phillips curve was flat. That led them to believe, “We can pump things up more and generate more employment, maximum inclusive employment, without risking higher inflation.”

Beckworth: So, we now know that the Fed did fall behind the curve when it came to inflation. It definitely raised rates too late and also dialed back on the asset purchases pretty late as well. And I guess, my question is, what of those other two options do you think made the biggest difference? Was it the asymmetric make-up policy that contributed most to the Fed's mistake, or was it the shortfalls part? Which of those two, or was it the combination of them working together?

Levy: David, I think it was the combination of the FAIT, the flexible average inflation targeting, that didn't have any numeric targets on it, plus the shortfalls notion. But also, I think a third factor is that it's the Fed's presumption that because inflation stayed low following the financial crisis, it would continue to stay low, even with zero rates and a ton of monetary and fiscal stimulus. It was that presumption that led them to make big mistakes. So, let's take each of those in turn. Whereas the 2012 consensus statement was symmetric around 2%, the new FAIT basically said, "Okay, let's have an explicit make-up policy to favor higher inflation following a period of sustained low inflation. Let's not put any numeric targets on it." Okay, so when inflation started rising, the Fed could say, "Hey, inflation's going to come back to 2%. So, when it all averages out, it's just part of our make-up strategy."

Levy: Following the huge pandemic shock and the contraction of the economy, the unemployment rate falls, employment's rising dramatically, yet the unemployment rate stayed above its pre-pandemic level. So, the Fed was able to say, "Well, we haven't achieved maximum inclusive employment." But then, lurking in the background— David, when you look at how the Fed responded when inflation started rising in 2021, the Fed initially, in spring of 2021, of course, called it transitory, and then they refined it to transitory supply shocks, and they initially said the higher inflation is good, because it means that the economy is bouncing back. Then, they persisted in saying, "Don't worry, it's just transitory." So, no matter how high inflation went, they continued to forecast that it would fall nearly immediately back to 2%.

Levy: What was interesting during this period is that the Fed really didn't refer specifically to its new strategic framework, but, in fact, it was abiding by it, because even though employment was increasing so rapidly, we clearly hadn't reached maximum inclusive employment. Because the Fed said, "Oh, don't worry, inflation's coming back to 2%," its FAIT was still consistent with its strategy. So, all in all, I think that the Fed used very bad judgment. Now, let me add one highlight to the bad judgment— two highlights. One is that, as inflation soared, they kept rates at zero, so the real fed funds rate became increasingly negative. And that was inconsistent with all simple Taylor rule-type estimates that said that the Fed needs to raise rates a lot. The Fed just used extraordinarily bad judgment.

Levy: Keep in mind, at the same time, you had unprecedented growth in the money supply, not just the monetary base, [which] is reserves plus currency. You had a 40% increase in M2 stemming from the confluence of monetary policy and fiscal policy that resulted from the Trump administration's and the Biden administration's excessive check writing to provide income support to people, the portion [that] was saved and ended up in bank accounts. So, the Fed used bad judgment based on any model, any standard model. The Fed used really bad judgment, and then add some seeming stubbornness to that.

Levy: Now, let me add one concluding point, is that even after the Fed acknowledged that, well, maybe not all of the higher inflation is transitory due to supply shocks and that we're going to need to raise rates through the first half of 2022— even after the Fed started raising rates, not just the median FOMC member, but all Fed members forecast or projected that the most appropriate fed funds rate response would be to raise the fed funds rate to keep it below inflation.

Levy: So, the Fed, even when it was playing catch-up after acknowledging that inflation was running up out of control, was far too timid in the end of 2021, [and in] the first quarter of 2022. And this just added up to really bad judgment. Some portion of that bad judgment was driven by, and consistent with, their strategic framework. But I want to emphasize that that strategic framework, which was asymmetric, was driven by their asymmetric presumptions that inflation was going to stay low.

Beckworth: So, you have several suggestions in the paper [about] how to improve the framework, and I want to get to those. But before we move on, one last observation and then question for you— and that is taking these past few years to heart, the lessons learned— and that is this, can we do make-up policy? So, one way to look at this period, and again, this is through my lens of nominal GDP, [is that] you can see the economy collapsed dramatically. We forcibly shut down the economy. Then, as you mentioned, President Trump, [and] then President Biden, they added fiscal stimulus. That closed the gap up, but by late 2021, nominal GDP was quickly back to where it would have been had there been no pandemic. Then, the issue arises when it overshoots that trajectory.

Beckworth: So, right now, the dollar size of the economy is roughly $2 trillion larger than had it been on a stable growth path for nominal GDP. Is it possible to thread that needle, to have a quick recovery, do make-up policy without overshooting, or is that the challenge, that it's hard to calibrate an exercise like that? Because look, I'm a fan of nominal GDP level targeting, which would call for make-up policy, but what we saw, effectively, was this massive overshoot of aggregate demand. Do you think there's any lessons here for whether such policies are even possible?

Levy: David, my response to that is that they should definitely be used as guidelines. You used the term “thread the needle.” So, let's be realistic. The pandemic was a true negative shock, and up until early '21, there were no vaccines. There was a lack of knowledge about the implications of this. You did have supply bottlenecks. And so, everybody was thrown a curveball. So, you could use the thread the needle term. The Fed faced very difficult circumstances, but it could have used broad guidelines. It could have looked at nominal. 

Levy: You bring [up] an outstanding point, and that is, while the Fed was attributing all of the higher inflation to transitory supply shocks, nominal GDP growth had accelerated to its fastest level in history. What was interesting about this [was that] in mid-2021, the beige books that were put together— anecdotal evidence from around the 12 Federal Reserve districts— acknowledged the strong rebounds, the strong aggregate demand that was providing flexibility to businesses to raise prices, but also put upward pressure on costs of production, of wages.

Levy: The Fed didn't even acknowledge that, or barely acknowledged it, in its semi-annual report to Congress. And so, if we could do this all over, we would say that there was a big negative supply shock and a shock to demand. The Fed faced tough issues. The unemployment rate, officially, went to nearly 15% and then came back down quickly. We really can't rely on the Phillips curve, but what could the policymakers have looked at?

Levy: They certainly could have looked at nominal GDP, and as you said, look at both the rate of growth of nominal and the level of nominal, [and] track the level of nominal compared to what it would have been if the Fed followed the pre-pandemic path as a measure of aggregate demand for the economy. The Fed could have looked at the unprecedented 40% surge in M2 and said, "What does this mean?" If you have an extra $6.5 trillion in, effectively, bank accounts, what are households and businesses going to do with it? What's happening to money velocity? Without being precise, people have different opinions about them, they could have been important benchmarks.

Levy: Now, let me add another benchmark that the Fed ignored, and that is fiscal policy. When the economy was all— the total, when you look at the fiscal responses to COVID, they added up to over 27% of GDP in deficits, most of which were direct transfers to households and to businesses. That was three times the magnitude of the decline in GDP. These were not reflected at all in the Fed's macro modeling of the economy. In fact, the economy was already rebounding sharply in the spring, and President Biden's first major piece of legislation was called the American [Rescue] Plan. It was passed [at the] end of March 2021, [and it] involved $1.9 trillion extra in deficit spending, nearly 10% of GDP. The checks were written. It didn't even move the dial on the Fed's next Summary of Economic [Projections] that came out in June. Why not?

Recommendations for the Fed’s Upcoming Framework Review

Levy: So, I'm broadening your point about, are there basic rules of thumb that we could have looked at, not to thread the needle, but to avoid making a major mistake? That basically gets to Charlie Plosser and my— our first basic suggestion for the upcoming strategic review, and [we] basically say, unlike the 2019 strategic review that was all skewed toward worrying about the effective lower bound and falling inflationary expectations, the Fed should really step back and use this strategic review period to say, "Wait a second, let's get back to basic issues of inflation and monetary policy."

Levy: It needs to really be very thoughtful here and do a thorough review of the inflation process and dynamics. Don't stick to the furthest model and models that only focus on wage and inflation dynamics within the labor market context, but look at broader views. If a time-varying Phillips curve is an inadequate basis for understanding inflation, [then] the Fed needs to consider other reliable frameworks for inflation.

Levy: It needs to analyze the key factors that are affecting aggregate demand, like the monetary transmission mechanisms that may have been affected by paying interest on reserves, by tighter capital controls following the financial crisis, [and] by the purchases in its balance sheet. It needs to consider fiscal policy. It needs to consider nominal GDP, broader issues. It needs to focus on the broad issues that affect aggregate supply and aggregate demand. These need to be on the table rather than these overly complex theoretical models that, unfortunately, don't have a great track record.

Beckworth: So, that was your first recommendation for this upcoming Fed framework review. Your second one is that the Fed needs a clear interpretation of its mandate. Speak to that.

Levy: Well, simply put, FAIT, the flexible average inflation targeting, that doesn't have any numeric targets on it, it's geared toward higher inflation. David, just think about where we are now. We've had the general price level go up several multiples of its earlier shortfall from where it would have been had it stayed at 2%. Yet, now, they're talking about, "Let's get inflation back to 2%." We applaud the Fed for saying, "We’re committed to getting inflation back to 2%," but it's basically saying, "We acknowledge that our FAIT is going to result in above-2% average inflation." Isn't that inconsistent with the Fed's objective of anchoring inflationary expectations?

Levy: So, when we say clarify, the reason why the Fed's 2012 strategic plan of just saying, "Hey, 2%, and we're symmetrical around it," the reason why it worked [was because] it told the public, told financial markets and the media, "Hey, our goal is 2%, because we think it's close enough to price stability and we're sticking to it." It needs to go back to clarify what it means. On the “maximum inclusive employment,” they can't drop the word inclusive now. It's just there, just forget about it. 

Levy: They need to restore the term “deviations” and drop the term “shortfalls” around that maximum inclusive employment, and it needs to emphasize that— regardless of the shape of the Phillips curve, the Fed needs to emphasize that, “We are going to move preemptively, in the future, if inflation goes up or inflationary expectations go up.” When we think about the Fed's dual mandate, the Fed needs to think about, how's the best way to achieve it, but also, you need to clarify, tell the public what you really mean by it.

Beckworth: So, what you've just said is that you want to restore the deviations around the natural rate of unemployment. So, symmetry, as opposed to the asymmetric shortfalls that's currently on FAIT with regards to maximum employment. What about the make-up part related to inflation? Would you get rid of that, or would you make it symmetric, or some other suggestion?

Levy: That's an interesting question, because you could really go either way on this. Do you want to target the general price level, or do you want to target inflation? In concept, I'm of the belief that a general price level— it would be great if it stayed at zero, but I certainly don't think that you need to be rigid on that. If they could just go back to 2% and say, "Let's keep it there," but be clear and say, "Okay, our goal, our objective is 2%," no fancy FAIT, just a simple 2%. Let the public know about it, [and] maybe add a numeric range around that to tell the market, “We understand that there's noise in the numbers, but we're going to respond when it gets outside of a range.” Just be simple.

Beckworth: So, you want to go from FAIT back to FIT, flexible inflation targeting, with that symmetric 2016 language in there, it sounds like.

Levy: That would be fine.

Beckworth: Okay, let's go on to your next suggestion, and that is, the Fed should review or consider systematic policy rules as guidelines in the conduct of its activities. So, what do you want there?

Levy: Simply put, the Fed shouldn't rigidly conduct policy according to a Taylor rule, or some of the variations on Taylor-type rules, but it should be very aware of what those rules are estimating. Whenever people bring up the idea of a Taylor rule, the Fed consensus is, "Oh, we can't be held down by a fancy formula." David, think of the following. There's always going to be discretion in the conduct of monetary policy, but if they were aware of what these rules are estimating, [then] they would definitely avoid major mistakes. And If the public and financial markets were aware that they're considering these rules, it will educate the public about a Fed reaction function, how it might respond to deviations of actual inflation and the unemployment rate or GDP from the desired path. So, it should definitely consider rules. And once again, if we go back to 2021, the systematic rules were so clear in saying that the Fed was falling further behind in a dangerous way.

Beckworth: Okay, your next one is that the Fed should dismiss the notion that forward guidance is an appropriate or effective independent tool of policy.

Levy: Okay, so, think about leading up to the pandemic and the Fed's strategic review. It relies on a macro model, and the macro model revolves around a Phillips curve and inflationary expectations. And as the Fed came around to acknowledge that the Phillips curve was less reliable than it had hoped, its primary tool was managing inflationary expectations, and it evolved into relying very heavily on forward guidance as an independent tool to manage inflationary expectations. That just doesn't make much sense. The Fed should be a little more circumspect in its power and what it's capable of doing.

Levy: What the 2021-2022 high inflation episode showed us is that the Fed's efforts to use forward guidance to try to manage inflationary expectations didn't work without backing up their forward guidance with actual monetary policy changes. In a sense, using forward guidance as an independent monetary policy tool— a little too much hubris there, and the Fed needs to be a little more circumspect about what it's capable of doing and not to fine-tune so much.

Beckworth: Okay, your final suggestion for rebooting the framework is that the Fed should clarify the quarterly SEPs and consider ways to improve them.

Levy: Okay, so, this is very important, because the Fed, since 2009, has provided these quarterly projections that are conditional, and the Fed states clearly that they’re conditional and they’re not binding. And they've become a very important avenue for Fed communications and providing forward guidance, but they tend to be misunderstood, and they need to be modified. So, think about the following. The SEPs are basically a compilation of projections of each FOMC member on real GDP, the unemployment rate, and inflation conditional on that Fed member’s estimates of the appropriate federal funds rate that would achieve their projections.

Levy: So, think about the following. It's almost required that in order to be consistent with their commitment to 2% long-run inflation, they have to project that inflation is going to come down toward 2%. So, then, David, the critical question becomes, what federal funds rate do they estimate is most appropriate to achieve that? What you find is, over time, the Fed's track record has been poor, but we can't disaggregate— The focus on the SEPs tends to be the median forecast, but because of an aggregation problem, you cannot identify the projections of any individual Fed member with their estimate of the appropriate funds rate, the dots.

Levy: So, one suggestion would be to reduce the emphasis on the median, which doesn't mean anything, and show that— anonymously, show a matrix of each Fed members’ projections on the economy, inflation and their estimate. So, there, you would be able to estimate a reaction function and learn about how the Fed thinks about the appropriate funds rate, which you can't decipher from the current SEPs.

Levy: Secondly, the Fed has stated that its balance sheet is a very important monetary policy tool, but it doesn't even mention it in their quarterly economic projection. So, a critical question is, how does the Fed's enormous balance sheet change in it? If it's an important policy tool, how does the Fed think about it and its impact on achieving their inflation and employment mandate? So, we would recommend including, in the SEPs, information on the balance sheet. That's a difficult issue, because different Fed members think of using the balance sheet for different purposes.

Levy: Finally, [there is] the Fed's poor track record on forecasting, and it goes way back to the early 1980s when they started providing semi-annual forecasts. Their track record has really been, let's use a charitable term, unreliable. Well, if it's unreliable, [then] the Fed should acknowledge that, and instead of basing all of their analysis on the best forecasts, the Fed should— maybe not every quarter, but once a year— have in its SEPs an exercise where it asks Fed members to respond to alternatives.

Levy: There are different ways that this could be done, but it could really be used to enhance risk management and the Fed's monetary policy deliberations, how it might respond when the economy, or inflation, or the unemployment rate are not following desired paths. And so, that could educate the public. It could educate Congress, specifically the Senate Banking Committee [and the] House Financial Services Committee. They're supposed to supervise the Fed. It could be an educational tool for the public, for Congress, and for the Fed and its deliberations.

Levy: So, those are just some of the suggestions that we make, and our bottom line, once again, is that the Fed, now that inflation has come down— It's still above 2%. Our concern is that the Fed, which tends not to like to change anything, its tendency might be to say, "Oh, don't worry, inflation's come down, we've got things under control, we don't need to change anything." What we're encouraging the Fed to do is really take to heart that this is a strategic review, where it could really go back to the basics and, in an unbiased, even-handed way, think about ways that it can really improve the conduct of monetary policy and be robust in doing so.

Beckworth: Well, you have some great suggestions to that end, and with that, our time is up today. Our guest has been Mickey Levy. Mickey, thank you so much for coming on the program.

Levy: Thank you.