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Improving Our Monetary Policy Strategy

Loretta J. Mester
President and Chief Executive Officer
Federal Reserve Bank of Cleveland
Panel Remarks for “Strategies for Monetary Policy: A Policy Conference”
The Hoover Institution, Stanford University
Stanford, CA
May 3, 2019

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Introduction
I thank John Taylor for inviting me to participate in this conference. It’s a real pleasure to be on a panel
moderated by Charles Plosser, whom I worked with at the Philly Fed. Although I learned a lot from
Charles, the views I’ll present are my own and are not necessarily shared by my fellow panelists, other
colleagues on the Federal Open Market Committee, or the Federal Reserve System.

The FOMC currently uses what has been called a flexible inflation-targeting framework to set monetary
policy. It is briefly described in the FOMC’s statement on longer-run goals and monetary policy
strategy. 1 In my view, this framework has served the FOMC well in effectively promoting our policy
goals. A milestone was reached in January 2012 when the U.S. adopted an explicit numerical inflation
goal. I am certain that Charles remembers very well the careful analysis and discussions that helped the
FOMC reach a consensus on the explicit 2 percent goal and the statement that describes the FOMC’s
approach to setting policy to promote its congressionally mandated goals of price stability and maximum
employment.

The FOMC is currently reviewing its policy framework. I am very supportive of this initiative. As a
matter of good governance, a central bank should periodically review its assumptions, methods, and
models, and to inform its evaluation, it should seek a wide range of perspectives, including those from
experts in academia, the private sector, and other central banks. Another motivation to undertake the
review now is that the post-crisis economic environment is expected to differ in some important ways
from the pre-crisis world. Based on the aging of the population and the expected slowdown in population
growth, higher demand for safe assets, and other factors, many economists anticipate that the longer-term
equilibrium real interest rate will remain lower than in past decades. 2 In fact, empirical estimates of the

1

See FOMC (2019).

2

See Mester (2018a).

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equilibrium real fed funds rate, so-called r-star, while highly uncertain, are generally lower than in the
past. 3 This means there is a higher chance that the policy rate will be constrained by the zero lower
bound, and that nontraditional monetary policy tools will need to be used more often. To the extent that
these tools are less effective than the traditional interest rate tool or are otherwise constrained, the
potential is for longer recessions and longer bouts of inflation well below target. 4 In addition, fiscal
policy’s ability to buffer against macroeconomic shocks is also likely to be constrained, given projected
large fiscal deficits and high government debt-to-GDP ratios. 5 This raises the question of whether
changes to our monetary policy framework would be helpful in maintaining macroeconomic stability in
this environment.

A number of suggestions have been made for alternative monetary policy frameworks that potentially
offer some benefits in a low-interest-rate environment. These include setting an inflation target that is
higher than 2 percent (an option not being considered by the FOMC in its framework review), using
price-level targeting or nominal GDP targeting instead of inflation targeting, targeting average inflation
over the business cycle or some other time frame, or using what former Chair Ben Bernanke has called
temporary price-level targeting (which is essentially doing inflation targeting in normal times and pricelevel targeting once the policy rate is constrained by the zero lower bound). An idea that has received
somewhat less attention is defining the inflation goal in terms of a range centered on 2 percent rather than
a point target. 6 Although these alternative frameworks have theoretical appeal, none of them is without
implementation challenges. For example, many of them work well in models of perfect credibility and
For FOMC projections, see FOMC (2014) and FOMC (2019). For a review of the literature on the equilibrium
interest rate, see Hamilton, et al. (2015).

3

Other government policies might also be brought to bear to increase the long-term growth rate and equilibrium
interest rate, which would give monetary policy more room to act. Such policies would focus on increasing
productivity growth and labor force growth.
4

5

See Peek, Rosengren, and Tootell (2018).

6

For further discussion of these monetary policy frameworks, see Mester (2018b) and Mester (2018c).

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commitment, where the public understands the framework and believes future Committees will follow
through, and the Committee actually does follow through, implying that the Committee has control of
inflation expectations. Whether these assumptions would hold in practice is an open question. One needs
to ask whether it is credible for policymakers to commit to keep interest rates low to make up for past
shortfalls of inflation from target even when demand is growing strongly or to act to bring inflation down
in the face of a supply shock by tightening policy even in the face of weak demand. It is not clear what
actually would happen to inflation expectations in these scenarios despite what is assumed in the models.
So the FOMC is going to have to evaluate the assumptions that drive the theoretical appeal of each
framework and determine whether in practice the net benefits of any of the alternatives will outweigh
those of the flexible inflation-targeting framework, and if not, what, if any, enhancements should be made
to our current framework.

Regardless of the framework the FOMC ultimately decides on, the public’s expectations about future
monetary policy are an important part of the transmission mechanism of policy to the economy. This
means effective communication will be an essential component of the framework. I believe there are
ways we can enhance our communications about our policy approach that would make any framework
more effective. Let me touch on three.

(1) Clarify how monetary policy affects the economy and which aspects of the economy can be influenced
by monetary policy and which aspects cannot.
Monetary policy is more effective when the public’s and market participants’ policy expectations are
aligned with our policy decisions. Before this alignment can occur, the public needs to have a basic
understanding of our monetary policy goals and what monetary policy can achieve and what it cannot.
My concern is that this understanding has diminished since the Great Recession. Regardless of the
framework, the FOMC’s strategy document should articulate the relationship between monetary policy
and our two policy goals of price stability and maximum employment. We should clarify that over the

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longer run, monetary policy can affect only inflation and not the underlying real structural aspects of the
economy such as the long-run natural rate of unemployment or maximum employment. Although this
concept is touched on in our current monetary policy strategy document, I do not think that the public
fully understands. Indeed, former Chair Janet Yellen had to explain in one of her post-FOMC meeting
press conferences that in an earlier speech, she did not mean to imply that she favored running a highpressure economy as an experiment to affect longer-run growth and unemployment. 7

I think we could do a better job of explaining how monetary policy promotes the economy’s growing at
potential and operating at maximum employment. In particular, we tend to move our policy rate up when
resource utilization tightens and down when resource utilization eases in order to bring our policy rate
into alignment with the economy’s natural rate of interest, which changes over the business cycle as the
economy adjusts to shocks. There doesn’t need to be an exploitable Phillips curve tradeoff between the
unemployment rate and the inflation rate in order for policymakers to want to respond to changes in the
unemployment rate, an indicator of resource utilization. 8 The response is not an attempt to actively use
monetary policy to affect the longer-run growth rate of the economy or the longer-run unemployment
rate. A benefit of explaining things in this way makes it clear that the FOMC is not trying to rob the
economy of jobs when it raises interest rates. Another benefit is that it should allay concerns that because
the empirical Phillips curve has flattened, monetary policy has become anemic.

Improving the public’s understanding of how monetary policy works and what it can achieve would help
not only in normal times but also in bad times. The Great Recession was an enormous negative shock,
some part of which was likely permanent or very persistent rather than transitory. Monetary policy

7

See Yellen (2016), p. 9.

8

Brainard (2018) discusses the shorter-run neutral rate and longer-run equilibrium interest rate.

5
should not have been expected to make up for that permanent loss. Fiscal policy should have taken on a
larger part of the burden.

(2) Clarify how uncertainty is accounted for in monetary policymaking and incorporate this uncertainty
into monetary policy strategy to avoid giving a false sense of precision.
According to Voltaire, “Uncertainty is an uncomfortable position, but certainty is an absurd one.” In our
context, this means it is important to convey that monetary policymakers have to deal with uncertainty in
several forms. Monetary policy has to be forward looking because it affects the economy with a lag, but
the economy is buffeted by shocks that can lead economic conditions to evolve differently than
anticipated. Moreover, our view of economic conditions in real time can be cloudy because the data
come in with a lag and many economic data are revised over time. In addition, there is model uncertainty.

The public needs to understand that given the lags and revisions in the data, incoming information can
alter not only the policymaker’s view of the expected future evolution of the economy but also his or her
understanding of current and past economic conditions. New information could alter the expected future
path of policy and might even result in ex post regret of a recent action. Robert Hetzel says that
policymaking has a flavor of “guess and correct.” 9 It is a normal part of monetary policymaking that
policymakers will always be learning about whether their policy settings are the appropriate ones to
promote their goals.

The public has to hold the FOMC accountable for its performance, but it should not hold monetary
policymakers to an unrealistic standard. The FOMC took an important step in communicating uncertainty
when it began showing 70 percent uncertainty bands around the median projections of FOMC
participants, but these are not emphasized. I think they deserve more attention and should be released at

9

See Hetzel (2019).

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the time of the post-FOMC press conference. They are a good illustration of the reasonable amount of
deviation to expect between the projections and outcomes. Some have argued that the FOMC’s
projections of appropriate monetary policy, the so-called dot plot, should be dropped because actual
policy can differ from the projections. I think that would be a mistake. The dots can change over time
because of economic developments, but that’s a design feature, not a flaw. Omitting the dot plot would
not eliminate the uncertainty around the projections, the divergence in views across FOMC participants,
or the fact that policymaking always entails learning and recalibration, but it would be a significant step
back in transparency.

We need to recognize uncertainty in our broader monetary policy strategy as well. Consider the FOMC’s
inflation target. After much deliberation, the Committee chose a point target instead of a range and a total
inflation measure rather than a core measure. While there were arguments on both sides, the Committee
was persuaded that a point target would better anchor inflation expectations. Implicit in the choice was
that the Committee would tolerate small deviations from target given the precision with which we can
measure inflation, the precision with which we can guide the economy, and the typical revisions to the
PCE inflation measures, which tend to be revised up over time. 10 It is interesting to think through
whether our policy choices or communications since 2012 might have differed had the Committee opted
for a range rather than a point target, as some other central banks do, and for a core measure rather than a
total measure of inflation. These data revisions and measurement issues, as well as potential difficulties
in maintaining anchored inflation expectations during the periods of higher inflation meant to make up for
periods of lower inflation, and vice versa, would seem to be amplified in price-level targeting and
nominal GDP targeting frameworks.

10
Croushore (forthcoming) finds that the average revision from initial release to first annual benchmark revision to
four-quarter PCE inflation over the period 1965Q3 to 2015Q4 was 0.10 percentage point and the average revision to
four-quarter core PCE inflation over the period 1995Q3 to 2015Q4 was 0.14 percentage point.

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(3) Clarify our monetary policy strategy by taking a more systematic approach to our policy decisions
and in how we communicate those decisions.
Households, businesses, and investors make economic and financial decisions based on their expectations
of the future, including the future course of monetary policy, and the FOMC strives to avoid surprising
the public with its policy decisions. The communications challenge for the FOMC is to give the public a
good sense of how policy is likely to respond conditional on how the economy evolves without implying
that policy is pre-committed to a particular policy path regardless of how the economy evolves.
Essentially, the FOMC needs to convey the strategy it uses to determine its policy actions over time to
promote achievement of its policy goals, i.e., its reaction function. And this will be true regardless of
which monetary policy framework the FOMC ultimately adopts. Ironically, the FOMC’s strategy
document does not offer much in the way of strategy, and this can lead to a misunderstanding that our
policy decisions are discretionary. The term “data-dependent” has been used to explain the FOMC’s
policymaking strategy, but this term could be potentially misinterpreted as suggesting that policy will
react to every short-run change in the data rather than the accumulation of changes that affect the
medium-run outlook.

A more systematic approach to setting monetary policy can better align the public’s policy expectations
with policy decisions and help to reduce some of the uncertainty around how we conduct monetary
policy. It can help insulate monetary policy from short-run political considerations, and it can also offer
more policy continuity over time as Committee members change. In a time of rising public skepticism
about “experts,” which can undermine public trust in institutions, being systematic will help the public
understand how our decisions are actually made, which can enhance the Fed’s credibility.

The question is how to ensure that we are setting policy systematically and how to convey this to the
public. I have three suggestions. First, while judgment will likely always be a part of policymaking,
simple monetary policy rules can play a more prominent role in our policy deliberations and

8
communications. 11 The FOMC has been reluctant to relinquish policymaking to following a simple rule,
because no one rule works well enough across a variety of economic models and circumstances. But the
Board of Governors has begun to include a discussion of rules as benchmarks in the monetary policy
report, 12 and frameworks that try to build in some commitments and constraints on future policy actions,
such as price-level targeting, average inflation targeting, and nominal GDP targeting, are being discussed.
This suggests that systematic policymaking is garnering more support. As a first step, selecting a few
benchmark rules that have been shown to yield good economic outcomes and using these as reference
points to aid policy discussions and communicating why our policy may or may not differ from the rules’
policy descriptions could go some way in ensuring that our decisions are derived in a systematic way and
could help us explain our own policy reaction function to the public.

A second suggestion is to enhance our own FOMC projections by asking the participants to provide a set
of economic projections conditioned on a common policy path, in addition to the current projections,
which are conditioned on each individual participant’s view of appropriate policy. This common path
might come from a policy rule. This would be a step toward achieving a coherent consensus FOMC
forecast, which has been a challenge but which could serve as the benchmark for understanding the
FOMC’s policy actions and post-meeting statements, a recommendation I have made in the past. 13

My third suggestion to help communicate systematic policymaking is to make our post-meeting FOMC
statement consistent from meeting to meeting and less focused on short-term changes in the data released
between FOMC meetings and more focused on the medium-run outlook and a consistent set of indicators
The Cleveland Fed provides updates for a set of monetary policy rules and their outcomes across several forecasts
on the Cleveland Fed’s website, and the Federal Reserve Board’s Monetary Policy Report now includes a section on
policy rules. See Federal Reserve Bank of Cleveland (March 22, 2019).
11

12

See Board of Governors (2019), pp. 36-39.

13
See Mester (2016). Hetzel (2019) also proposes a method to determine an FOMC consensus forecast that would
entail the Committee’s agreeing to its preferred reaction function at the start of each year, and then using an iterative
process among FOMC members based on that rule and the Board staff’s economic model.

9
on inflation, inflation expectations, the unemployment rate, employment growth, output growth, and
financial conditions. Each statement could provide the rationale for the policy decision in terms of how
accumulated changes in this consistent set of economic and financial conditions have or have not
influenced the Committee’s assessment of the factors relevant for policy, i.e., the arguments in our
reaction function. The statement would also consistently articulate the Committee’s assessment of risks
to the outlook and other considerations that the Committee is taking into account in determining current
and future policy. This assessment would be informed by the analysis of alternative forecast scenarios,
which are discussed at each FOMC meeting. If we provided more consistency about the conditions we
systematically assess in calibrating the stance of policy, the public and market participants would get a
better sense of the FOMC’s reaction function over time and their policy expectations would better align
with those of policymakers.

I note that all of the suggestions I have made today are relevant regardless of the framework the FOMC
ultimately decides to use for setting monetary policy.

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References
Board of Governors of the Federal Reserve System, “Monetary Policy Report,” February 22, 2019.
(https://www.federalreserve.gov/monetarypolicy/files/20190222_mprfullreport.pdf)
Brainard, Lael, “What Do We Mean by Neutral and What Role Does It Play in Monetary Policy?”
Remarks at the Detroit Economic Club, Detroit, MI, September 12, 2018.
(https://www.federalreserve.gov/newsevents/speech/brainard20180912a.htm)
Croushore, Dean, “Revisions to PCE Inflation Measures: Implications for Monetary Policy,”
International Journal of Central Banking (forthcoming).
Federal Reserve Bank of Cleveland, “Simple Monetary Policy Rules,” update of March 22, 2019.
(https://www.clevelandfed.org/en/our-research/indicators-and-data/simple-monetary-policy-rules)
FOMC, “Minutes of the Federal Open Market Committee, March 18-19, 2014,” April 2014.
(https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20140319.pdf)
FOMC, “Minutes of the Federal Open Market Committee, March 19-20, 2019,” April 2019.
(https://www.federalreserve.gov/monetarypolicy/files/fomcminutes20190320.pdf)
FOMC, “Statement on Longer-Run Goals and Monetary Policy Strategy,” January 29, 2019.
(https://www.federalreserve.gov/monetarypolicy/files/FOMC_LongerRunGoals.pdf)
Hamilton, James D., Ethan S. Harris, Jan Hatzius, and Kenneth D. West, “The Equilibrium Real Funds
Rate: Past, Present and Future,” U.S. Monetary Policy Forum, February 2015, revised August 2015.
(https://research.chicagobooth.edu/-/media/research/igm/docs/2015-usmpf.pdf)
Hetzel, Robert L., “Rules versus Discretion Revisited: A Proposal to Make the Strategy of Monetary
Policy Transparent,” unpublished manuscript, March 20, 2019.
Mester, Loretta J., “Demographics and Their Implications for the Economy and Policy,” Cato Journal 2
(Spring/Summer 2018a), pp. 399-413.
(https://www.cato.org/cato-journal/springsummer-2018/demographics-their-implications-economypolicy)
Mester, Loretta J., “Monetary Policy Frameworks,” National Association for Business Economics and
American Economic Association Session at the Allied Social Sciences Association Annual Meeting,
Philadelphia, PA, January 5, 2018b
(https://www.clevelandfed.org/newsroom-and-events/speeches/sp-20180105-monetary-policyframeworks)
Mester, Loretta J., “Remarks on the FOMC’s Monetary Policy Framework,” panel remarks at the 2018
U.S. Monetary Policy Forum, sponsored by the Initiative on Global Markets at the University of Chicago
Booth School of Business, New York, NY, February 23, 2018c.
(https://www.clevelandfed.org/newsroom-and-events/speeches/sp-20180223-remarks-on-the-fomcsmonetary-policy-framework)

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Mester, Loretta J., “Acknowledging Uncertainty,” Shadow Open Market Committee Fall Meeting, New
York, NY, October 7, 2016.
(http://www.clevelandfed.org/en/newsroom-and-events/speeches/sp-20161007-acknowledginguncertainty)
Peek, Joe, Eric S. Rosengren, and Geoffrey M.B. Tootell, “Some Unpleasant Stabilization Arithmetic,”
presentation at the Federal Reserve Bank of Boston’s 62nd Economic Conference, “What Are the
Consequences of Long Spells of Low Interest Rates?” Boston, Massachusetts, September 8, 2018.
(https://www.bostonfed.org/news-and-events/speeches/2018/some-unpleasant-stabilizationarithmetic.aspx)
Yellen, Janet, “Transcript of Chair Yellen’s Press Conference,” December 14, 2016.
(https://www.federalreserve.gov/mediacenter/files/FOMCpresconf20161214.pdf)