Notes of a talk with an American professional central bank analyst

(normal font my comments, italics his)


The conclusion of the FED policy review, and the change in the

Statement on Longer-Run Goals and Monetary Policy Strategy

raised two puzzles with me.

First, the review seems to have had as the most important conclusion the revision of the inflation objective. But that seemed to be exactly the issue that surprised for its little prominence in  all the « FED-listens» exercise.

« …, there was less discussion at the Fed Listens events of inflation than there was of labor market conditions.  

When discussion turned to the possibility that the Fed might want to nudge inflation higher— which occurred at a few of the events—participants generally had little understanding for why policymakers would be concerned about inflation running below the Federal Reserve’s 2 percent objective. « (Emphasis added.) 

Indeed, inflation, and in particular the fact that it was for very long below the target, did not seem to raise interest in the wide circle of people that participated in the Fed-listens initiative. There was much more attention to the employment/unemployment issue. This is consistent with the other important change in the FED strategy statement: the transition from “deviations” to “shortfalls” in the assessment of the employment objective. This is tantamount to asymmetrically reducing the weight of the Nairu/u* in the reaction function of the FED (give less importance to unemployment when it is lower than Nairu). This change is consistent with the stress in recent FED statements on social aspects of monetary policy. Still, an estimate of this rate will be published in the SEP (Summary of Economic Projections) of the FOMC. This change, introducing asymmetry in the FED reaction function as regards employment, was less expected by market participants and reinforced the dovish message coming from the review results. Another consequence of the change in the strategy will be enhanced attention to, variously measured, inflation expectations.

This gave me a hook to mention once more my pet idea about using inflation derivatives as a new monetary policy tool.

Second, I fail to be so impressed by the change, given where the FED already was. The market seemed not to move much at Powell’s speech, while the market commentary that I have seen gives much more prominence to the strategy change.

The Fed wrote that:

“The 2012 statement was a significant milestone, reflecting lessons learned from fighting high inflation as well as from experience around the world with flexible inflation targeting. The statement largely articulated the policy framework the Committee had been following for some time. »

Could one in the future say the same about the 2020 Monetary policy review? Is the change brought up in market commentary exaggerated?

How credible is the goal to recoup so persistent past misses of inflation by averaging the goal? Is it not, in current conditions, a bit like raising the inflation objective? And one could add that the FED has chosen a bland variant of average inflation targeting, which is in turn a bland form of price level targeting:

“the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time. » (Emphasis added.)

It was useful that the FED made explicit that it is now following an average inflation over time, having moved from a “bygones are bygones” approach to a “with memory” approach. But one should not get too excited by the change. The limited market impact can be explained, as argued by Clarida in the PIIE interview, by the fact that the change was expected and indeed had already caused an increase, significant even if not large, of inflationary expectations and a reduction of real interest rates. Ideally, one would want to see an increase in inflation to something like 2.3% in the SEP five year forward. In practice this is not possible, because projections do not go so far in the future. It would seem also logical that, after having given the revised general approach to monetary policy, the FED would also announce, probably already at the September meeting, more specific indications about forward guidance of the state contingent kind, as well as about bond purchases. But there is not much indication of this in the various statements by FED representatives, who seem to indicate that the issue is not urgent. Thus, it is not easy to give a probability to a possible action already in September.

The FED has a quantitative inflation goal to be pursued on average, a non-quantitative employment goal and a softer financial stability goal

“…sustainably achieving maximum employment and price stability depends on a stable financial system. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee’s goals. »

The issue is what to do (the term balancing is not used any more, possibly always to give a dovish tone to the statement) when inflation and employment are not complementary:

“…under circumstances in which the Committee judges that the objectives are not complementary, it takes into account the employment shortfalls and inflation deviations and the potentially different time horizons over which employment and inflation are projected to return to levels judged consistent with its mandate. »

But nothing is said when financial stability, on one hand, and employment and inflation, on the other hand, are not complementary. Overall it looks to me a fairly complicated set-up, not fully consistent with an independent central bank, as it seems to have to arbitrage between objectives, which only an institution with political discretion can do.

Indeed, the issue is quite complex. In particular the possible contrast between financial stability risk and the pursuit of the dual inflation/employment objective is not clarified. This also depends on the fact that, analytically, the relationship between low interest rates and financial stability risk is difficult to assess and quantify. In any case it is an easy forecast that the Fed will not tighten monetary policy, with possible negative effects on employment, just because of financial stability risks. This could indeed become an issue since there is currently a decent amount of financial stability risk in the economy as seen in asset prices, particularly the stock exchange.

I noted something of a contradiction in two statements of the former FED Chair, Yellen. When she was at the helm of the FED, if asked about a possible contrast between financial stability and the inflation/employment objective, she said that the first line of defense should be macroprudential measures. In contrast, she recently said (at the Bruegel annual meetings) that macroprudential policy is not available in the US, since the Financial Stability Oversight Council is not properly equipped for that.


On the ECB I made 3 points:

  • The supervisory wing of the ECB has recently acted like a macroprudential institution, at least for banks, lessening the fear that also in the EU the macropru instrument would not be available
  • Is the « symmetry» in the inflation objective stressed by the ECB a harbinger of make-up/average inflation?
  • Will the ECB have to follow in the direction of tilting in a dovish direction its inflation objective because of the FED example and the strengthening of the € exchange rate?

On the first point I noted that the ECB strongly reduced capital charges for banks just when there is more risk because of COVID 19, which can only be justified in a macropru approach.

On the second point I noted three statements that, at least partially, show that the ECB could also move towards some form of make-up inflation.

Villeroy de Galheau:

PARIS (Reuters) – “The European Central Bank’s inflation target must be symmetric, flexible and credible with the general public rather than just financial markets, ECB policymaker Francois Villeroy de Galhau said on Thursday. For much of the last decade, euro zone inflation has fallen short of the current target for a rate of close to but less than 2% over the medium term, prompting new ECB President Christine Lagarde to launch a review of the objective.Weighing into the debate, Villeroy said there should be a equal tolerance for inflation both undershooting and overshooting the target.” (Emphasis added)


“In addition, we clarified that symmetry meant not only that we would not accept persistently low inflation, but also that there was no cap on inflation at 2%. As I emphasised on a number of occasions, our medium-term orientation implies that inflation can deviate from our aim in both directions, so long as the path of inflation converges back towards that focal point over the medium-term policy horizon. Sintra 2020.”

Press conference in March 2016: “our mandate is defined as reaching an inflation rate which is close to 2% but below 2% in the medium term, which means that we’ll have to define the medium term in a way that, if the inflation rate was for a long time below 2%, it will be above 2% for some time. The key point is that the Governing Council is symmetric in the definition of the objective of price stability over the medium term.” (Emphasis added)


“On the inflation target, we have a policy by which we operate. We have a strategy that was defined and that has inspired the policy decisions that were made and that have been made up until this day. That will continue to inspire the policy decisions that are made until a strategy has been adopted – which is a while from now but I’m sure you’ll have questions about the strategy. In that respect, I would just adhere to what that strategy was, what its developments were over the course of time. I think the point of symmetry is very clearly referred to in the introductory statement.”

So the current Chair has been, at least so far, much more cautious than the previous Chair in moving towards average inflation.

At the end of the monetary policy review, I expect the ECB will make some limited concessions to average targeting.

On the third point I noted that, with an 8% effective appreciation of the € since February and an elasticity of 0.1 between the exchange rate and both growth and inflation, there is a significant effect on both. On GDP this may seem small, given the recent extreme volatility, but this is not the right perspective: 0.8% GDP effect is not insignificant.  On inflation, 0.8% is large, given a core rate of 0.4% currently.

Will this cause a change in ECB Monetary policy?

Not directly and not soon, but the effect on inflation will be noted and one can expect exchange rate considerations (e.g. the number of times the term is mentioned in the press conference to become more important).