Jul 31, 2020

Quick Reads: Staying the Course

At the most recent FOMC meeting, Powell and the Fed commit to steadying the economy
Marc Dupont Staff Writer

In a relatively expected turn of events, the Federal Reserve Open Market Committee (FOMC) and Fed chairman Jerome Powell announced Wednesday that they remain committed to utilizing their “full range of tools” in order to steady the virus-stricken US economy. As Powell noted during Wednesday’s press conference, these actions are justified given the recent signs of renewed economic stagnation following a resurgence in COVID-19 cases across the country.

In lockstep with this new information regarding the virus and the economy, Powell and the Fed also announced that they will keep current interest rates in the 0 to 0.25 percent range, a predictable response to the uncertain economic conditions caused by the pandemic. Additionally, the FOMC stated that it will continue to increase purchasing Treasury securities as well as mortgage-backed securities in an attempt to support credit flows to households and businesses. This decision also came after its announcement on Tuesday to extend the current emergency lending programs, which were set to expire at the end of September, through the end of this year.

None of these moves by the Fed should come as a surprise, as Powell reiterated during Wednesday’s press conference. He noted that “preserving the flow of credit is thus essential for mitigating the damage to the economy and promoting the economy.” As conditions remain uncertain, the Fed will naturally stay the course, using its expanded toolkit to steady the ship and prevent any further macroeconomic crises that could stem from the pandemic.

Although Powell noted that household spending has begun broadly to show signs of recovery, he also acknowledged that second-quarter real GDP growth will likely show the largest contraction on record. (The next day, the Commerce Department reported a staggering 9.5 percent drop in GDP.)

Powell also gave an update on the progress of the Fed framework review, a broad evaluation of monetary policy strategy, tools, and communications conducted internally by the central bank. The chairman said that “[the Fed’s] plans to conclude this review were . . . delayed by the pandemic,” and that while no update was given, he was “confident that we will continue to make progress and will wrap up our deliberations by the near future.”

As we wait for the outcome of this framework review, it is more important than ever to highlight the need for the Fed to be more aggressive with its policy tools in the future to combat a potentially weak economic recovery once the pandemic has run its course. One of the ways it can do this is through effectively communicating and adopting a credible makeup policy that would allow it to “run the economy hot”. This would entail the Fed tolerating a surge of inflation above its current 2 percent target for a period of time sufficient to allow the economy to return to precrisis levels. However, another solution could come in the form of adopting a new explicit target, such as a wage growth or nominal income—also known as nominal GDP—target.

Currently, there is a massive $2.87 trillion gap between the actual and expected dollar sizes of the economy for the second quarter, a gap which is expected to shrink to only $1.63 trillion by the end of this year. Simply put, the expected dollar size represents the level of dollar income within the economy that is required to prevent pervasive financial hardship for businesses and families, while the actual figure represents the size of the economy as measured by nominal GDP. This would seem to indicate that if the Fed sticks to its current 2 percent inflation target, the economy will be in for another long and slow recovery, similar to the low levels of growth that followed the 2008–2009 recession.

Through adopting a nominal GDP level target, the Fed will be able to change this course and, through proper forward guidance, communicate a willingness to do whatever it takes to restore total dollar income to a pre-recession growth path. In short, a target focusing on nominal GDP would put the economy back on track to the levels of growth forecasted before the pandemic swept through the country. This would not only satisfy the Fed’s current mandate of stable prices and full employment, but it would also ensure that the central bank avoids impeding a swift recovery.

Over the past few months, the Federal Reserve has done a fantastic job responding to the crisis at hand, but now is the time to put its foot on the gas pedal. Instead of waiting until the end of the year to complete a review and possible revision of its current framework, the central bank should take action as soon as possible to commit to pursuing a robust recovery.

Marc Dupont is a research assistant at the Mercatus Center.

Photo credit: Samuel Corum/Getty Images

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