Related Links

• The Origins of the Fed's 2 Percent Inflation Target, Econ Focus
• The Legacy of Marvin Goodfriend, Speaking of the economy
• Honoring Marvin Goodfriend
• Review of Monetary Policy Strategy, Tools, and Communications, Federal Reserve Board of Governors
• The Great Inflation, Federal Reserve History

Transcript

Tim Sablik: My guest today is Alexander Wolman, vice president for monetary and macroeconomic research at the Richmond Fed. Alex, welcome back to the show.

Alexander Wolman: Thanks, Tim. It's great to be back on the pod with you.

Sablik: You joined me back in 2022 to talk about your research on the impact of relative price changes on overall inflation. And we're still continuing the conversation on inflation today with a look at the Fed's long-run inflation target, which is 2 percent.

In 2021 and 2022, inflation surged well above that level to rates not seen in 40 years. At that time, there were plenty of comparisons to the earlier Great Inflation period of the 1970s and 1980s. But things have played out quite differently so far. Can you talk about some of those key differences?

Wolman: Sure.

By 1980, when inflation reached its peak during the Great Inflation, high inflation had become embedded in long-term inflation expectations and then long-term interest rates. In contrast, while short-term inflation expectations did move up quite a bit in 2021 and 2022 when inflation rose, long-term inflation expectation measures have been remarkably stable. So that's an important difference.

Furthermore, the substantial decrease in inflation that we've seen thus far has come with barely any increase in the unemployment rate, whereas in the early '80s as inflation came down, the unemployment rate rose quite dramatically.

Sablik: One key difference between the current period of inflation and the past Great Inflation is the Fed's policy framework, which includes the 2 percent inflation target. We recently published an article about the origin of the Fed's 2 percent target in Econ Focus magazine, and we'll include a link for interested listeners to check that out.

For our listeners now, can you give us an overview of the Fed's framework today and how it compares to the monetary policy framework during the Great Inflation?

Wolman: The Fed has a mandate from Congress to conduct policy in a way that promotes effectively the goals of maximum employment, price stability, and moderate long-term interest rates. But that's very broad and not really operational. Furthermore, it doesn't say anything about what price stability means.

In January 2012, the FOMC adopted for the first time a Statement on Longer-Run Goals and Monetary Policy Strategy, which explicitly specified inflation at 2 percent as a long-run goal. This goal was generally complimentary with the goal of maximum employment. The statement that was adopted in 2012 emphasized that in contrast to inflation, which monetary policy has the ability to control over the longer run, maximum employment is largely determined by non-monetary factors that may change over time and not be directly measurable.

Every January after 2012, the FOMC reinforced its commitment to that Statement on Longer-Run Goals and Monetary Policy Strategy, with some minor changes along the way. But in August 2020 — in the wake of several years of inflation somewhat below 2 percent, in a situation where interest rates had been at their lower bound, and in the midst of the pandemic — the FOMC made more significant changes to its statement of longer-run goals. With respect to inflation, the Committee stated that following periods when inflation had been running persistently below 2 percent, it would likely be appropriate to aim for inflation moderately above 2 percent for some time. This approach has been referred to as flexible average inflation targeting.

In my mind, there's a second important component of the Fed's current policy framework, going back to 2012 when it was originally adopted, and that is the Summary of Economic Projections or SEP. Four times a year, each FOMC participant — the seven Governors of the Federal Reserve Board and the 12 Federal Reserve Bank presidents — each submit projections for inflation, real GDP growth, the unemployment rate, and the target federal funds rate under the assumption of appropriate monetary policy. These projections go out two to three years but also include values for the longer run. I view those as an important part of the monetary policy framework because they provide a way for the FOMC to continually reinforce its commitment to achieving the inflation target in the longer run.

Of course, that commitment has to be reinforced by actions. If the Committee were to have the statement on longer-run goals in place and produce its Summary of Economic Projections four times a year showing inflation coming back to target but we went for 10 years without it happening, then the whole thing would be useless. Thus far, that's not what has happened, although, of course, inflation has not come back fully to target. So, that needs to happen. I expect that it will.

The Committee has also stated that it expects to undertake a thorough review of its monetary policy framework roughly every five years. The next review will begin late this year, with the results announced about a year later. So, maybe we can reconvene middle of next year or late next year to talk about what has come of that.

Sablik: Yeah, that sounds great.

Wolman: If I could continue a little bit, you also asked about the Fed's monetary policy framework during the Great Inflation and how did that compare. The contrast is quite stark.

The mandate from Congress that I mentioned earlier was introduced during the Great Inflation, but there was little else in terms of a framework. The '70s had begun with the unraveling of the Bretton Woods fixed exchange rate system, which in principle had provided a guiding framework for monetary policy in the '60s. With Bretton Woods gone and nothing in its place, and with large oil price shocks, it's perhaps not surprising that inflation ratcheted up. By the end of the '70s, high inflation had become entrenched — both in the expectations and behavior of firms and consumers — and also in very high long-term nominal interest rates.

Sablik: As you mentioned, the Fed first adopted its long-run framework with the 2 percent target in 2012. But the idea of an inflation target was something that was decades in the making. Can you talk briefly about the changes in monetary policy and economics that ultimately led to the adoption of an inflation target?

Wolman: Over the 1980s and early '90s, the Fed did succeed in bringing inflation down from its high levels to around 2 percent. It's somewhat remarkable that the Fed succeeded in doing that, given that it did not have an explicit guiding framework apart from its congressional mandate to pursue maximum employment, stable prices, and moderate long-term interest rates.

In the mid '90s, with inflation down to an acceptable level, the question then became, is there something the Fed can do to help maintain low and stable inflation? Starting earlier in the '70s, advances had been occurring in macroeconomics which supported formal inflation targets. This was work that involved how one models the macroeconomy, but also the work that emphasizes the importance of credibility in monetary policy.

Sablik: Some of those advances actually happened at the Richmond Fed. What role did Richmond researchers and policymakers play in the decision to adopt an inflation target?

Wolman: Marvin Goodfriend was an economist, research director and advisor to the Richmond bank president. Marvin did important work on secrecy and central banking, which contributed to the Fed becoming more transparent. Inflation targeting requires a certain degree of transparency. Marvin did a lot of the early work that contributed to the academic and policy case for inflation targeting.

Richmond President Al Broaddus then brought that message to the FOMC with Marvin as his main advisor. Then, President Jeff Lacker was on the FOMC in 2012 when the inflation target was adopted.

I'll also mentioned a couple other things that came out of Richmond. First is Bob Hetzel [and] his work on index bonds and on monetary history, and then Tom Humphrey's work on the history of thought in monetary economics. All those things contributed to the case for some sort of explicit inflation targeting policy.

If listeners are interested in learning more about these issues and ideas, and in particular the contributions of Marvin Goodfriend and others at the Richmond Fed, I encourage them to dig up an earlier podcast you and I did with Bob King back in 2022, as well as the volume of essays honoring Marvin Goodfriend that Bob King and I edited.

Sablik: Yeah, we'll definitely include links to those in the show notes.

Another question that I think comes up a lot with this topic is where did the actual 2 percent number come from?

Wolman: It's funny. That's a question that I get asked so often. I have an almost canned response.

I've got to hand it to Matt Wells, who wrote the Econ Focus article, for tracking down a quote from Ben Bernanke before he was chairman of the Fed. I can't do any better than just to read that quote: "The lowest inflation rate for which the risk of the funds rate hitting the lower bound appears to be acceptably small." I think, yeah, that's really the answer.

Earlier, there had been work which emphasized measurement error in the Consumer Price Index — when the CPI was measuring at, say, about 1 percent, that actually meant inflation properly measured was closer to zero. So, before this zero bound issue was really foremost in people's minds, I think measurement error was leading the profession to think that a somewhat positive rate of measured inflation was true price stability. Then the zero bound kind of came along and made people bump up their optimal inflation rate a little bit more.

Sablik: Right. Just to clarify for those who might not be familiar with the zero bound problem, the issue is that the Fed wants to keep inflation somewhat higher in order to reduce the frequency that interest rates are at their lower bound of zero, for a variety of reasons.

We now have over a decade of experience with inflation targeting in the United States, and even longer when looking at some other countries that adopted an explicit inflation target earlier than that. What have we learned about its effectiveness?

Wolman: That's a great and an important question.

The vision of inflation targeting that I absorbed from Marvin was that it could help to anchor long-term inflation expectations, keeping long-term interest rates at moderate levels. When shocks inevitably hit that raise inflation or when monetary policy temporarily, even accidentally, deviated from its normal procedures in a way that caused inflation to rise or fall, that rise in inflation would not get built into long-term bond rates. Without higher bond rates, the necessity of higher unemployment to bring inflation back to target is vastly reduced. And in the current situation, it hasn't appeared at all.

Marvin also emphasized that an inflation target would free up monetary policy to adjust cyclically as economic fundamentals warranted, and without those policy adjustments causing inflation expectations to drift. Some might argue that inflation targeting would inevitably sow the seeds of its own destruction, as policymakers would be tempted by this newfound freedom to try to exploit it excessively.

That's where I think that the Summary of Economic Projections, which I mentioned earlier, serves an important role, together with the fact that the FOMC chair and all the members have made themselves accountable to the public, not just to Congress, by regularly giving speeches and interviews, and in the chair's case with the post-meeting press conference.

So, I believe that in the current situation while inflation is not yet back to target, the role of having the inflation target has been significant. We've not seen an un-anchoring of inflation expectations and inflation has come quite a bit of the way back to target without any apparent deterioration in the employment situation.

Sablik: Well, Alex, thanks so much for joining me today.

Wolman: My pleasure, Tim.