Vice Chair Clarida has published a paper titled “The Federal Reserve’s New Framework: Context and Consequences”. This paper represents his main legacy. Please, find below a short summary of the paper, the most relevant parts of it, and our comments.
What the paper does
The paper discusses the factors that motivated the Federal Reserve to announce the review of its monetary policy strategy, tools, and communication practices. It then considers the major findings of the review and highlights some important policy implications that flow from them.
Goal
Clarida: “The goal of monetary policy after lifting off from the ELB is to return inflation to its 2 percent longer-run goal, but not to push inflation below 2 percent”.
Comment: when the strategy review was announced, the level of underlying inflation was below target (as well as long-term inflation expectations were at a level not consistent with the 2 percent objective). For this reason, Clarida seems to remark that the real objective of the strategy review was (and still is) to make sure that underlying inflation raises to two percent (or alternatively that expectations are at a level consistent with target). In this respect, the latest FOMC minutes contained a clear statement indicating that, according to the Fed staff, pi* is moving and will gradually converge to 2 percent in the medium-term.
Expectations
Clarida: “With regard to inflation expectations, there is broad agreement among academics and policymakers that achieving price stability on a sustainable basis requires that inflation expectations be well anchored at the rate of inflation consistent with the price-stability goal.” Comment: despite the significant deviation of inflation in 2021 from the estimated fundamentals, Clarida continues to think about inflation dynamics in terms of an augmented Phillips curve framework. In such a model, long-term inflation expectations determine (in fact, they are equal to) pi*.
Clarida: “I follow closely the Fed staff’s index of common inflation expectations (CIE)—which is now updated quarterly on the Board’s website—as a relevant indicator that this goal is being met. Other things being equal, my desired pace of policy normalization post liftoff to return inflation to 2 percent would be somewhat slower than otherwise if the CIE index at the time of liftoff is below the pre-ELB level.” Comment: in our view, this will be one of his legacies. For this reason, we have replicated the CIE model and we nowcast it. In the latest run, the level of the Fed CIE is estimated to be consistent with a reading of core PCE price inflation of 2 percent. Put it differently, the conditions for liftoff using the Fed CIE appear to be met.
Taylor rule
Clarida: “The relevant policy rule benchmark I will consult after the conditions for liftoff have been met is an inertial Taylor-type rule with a coefficient of zero on the unemployment gap, a coefficient of 1.5 on the gap between core PCE inflation and the 2 percent longer-run goal, and a neutral real policy rate equal to my SEP projection of long-run r*.
Comment: Clarida refers to a slightly modified version of the Fed staff (2021) Taylor rule (with a coefficient of zero on the unemployment gap). In any case, even this modified rule implies 4 hikes in 2022 (assuming that maximum employment is reached when U<U*).
Pi*
Clarida: “I continue to believe that the underlying rate of inflation in the U.S. economy is hovering close to our 2 percent longer-run objective and, thus, that the unwelcome surge in inflation in 2021, once these relative price adjustments are complete and bottlenecks have unclogged, will in the end prove to be largely transitory under appropriate monetary policy”.
Comment: Clarida refers directly to the Fed staff framework of core PCE price inflation, confirming that the behavior of pi* (underlying inflation) is, in fact, crucial for policy makers and somehow more important than the behavior of actual/observed inflation.
Liftoff
Clarida: “Thus, the course of the labor market and, indeed, that of the economy continue to depend on the course of the virus, though my expectation today is that the labor market by the end of 2022 will have reached my assessment of maximum employment if the unemployment rate has declined by then to the SEP median of modal projections of 3.5 percent”.
Comment: This is a bit surprising and more dovish than expected. We think that most participants at this point consider the US economy at (or near) full employment and that the inflation risks are too elevated. For this reason, we continue to expect liftoff to occur in March.