For release on delivery
4:40 p.m. EDT (3:40 p.m. CDT)
June 18, 2022
Lessons Learned on Normalizing Monetary Policy
Remarks by
Christopher J. Waller
Member
Board of Governors of the Federal Reserve System
at
"Monetary Policy at a Crossroads," a panel discussion hosted by
the Dallas Society for Computational Economics
Dallas, Texas
June 18, 2022
Thank you, Meredith and Cullum and thank you to the Society for the invitation
to speak to you today. This week, the Federal Open Market Committee (FOMC) took
another significant step toward achieving our inflation objective by raising the Federal
Funds rate target by 75 basis points. In my view, and I speak only for myself, if the data
comes in as I expect I will support a similar-sized move at our July meeting. The Fed is
"all in" on re-establishing price stability, and part of that effort involves understanding
the forces that have boosted inflation and also examining how policymakers responded.
Today, I intend to look back on monetary policy in 2020 and 2021, as I have before in
recent speeches, but go a bit further and try to discern some lessons learned.1
In addition to the Federal Reserve's emergency lending programs, the monetary
policy actions taken during this time were deemed extraordinary. We swiftly lowered the
target range for the federal funds rate to close to zero-the effective lower bound-and
made an open-ended commitment to purchasing securities. It was only the second time
that the Fed had taken such dramatic steps. But the first time for these actions was
scarcely a decade ago, and there is good reason to think such a response may not be
extraordinary anymore. Structural changes in the economy have tended to lower interest
rates and limit the room that the Federal Reserve will have to cut rates during a
slowdown.2 I hope we never have another two years like 2020 and 2021, but because of
1See Christopher J. Waller (2022), "Reflections on Monetary Policy in 2021," speech delivered at the 2022
Hoover Institution Monetary Conference, Stanford, California, May 6,
https://www.federalreserve.gov/newsevents/speech/waller20220506a.htm; and Christopher J. Waller
(2021), "A Hopeless and Imperative Endeavor: Lessons from the Pandemic for Economic Forecasters,"
speech delivered at the Forecasters Club of New York, New York, December 17,
https://www.federalreserve.gov/newsevents/speech/waller20211217a.htm. These remarks represent my
own views and not any position of the Federal Reserve Board or the Federal Open Market Committee.
2
Research has suggested a large number of developments may have contributed to a decline in the
equilibrium real interest rate, focusing on factors that may have shifted aggregate savings and/or investment
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the low-interest-rate environment we now face, I believe that even in a typical recession
there is a decent chance that we will be considering policy decisions in the future similar
to those we made over the past two years. Because of that likelihood, it is especially
useful to consider the lessons learned.
Let's start at the beginning, when the United States was faced with the economic
shock from COVID-19. Over several weeks starting in early March 2020, the FOMC
lowered the target range for the federal funds rate to the effective lower bound and began
purchasing Treasuries and agency mortgage-backed securities (MBS). Meanwhile, the
Fed established numerous liquidity and credit market facilities.3 All these actions were
taken to support liquidity in the financial system and keep credit flowing to households,
businesses and state and local governments. Asset purchases were undertaken in
response to disruptions in financial markets, particularly in the normally stable U.S.
Treasury market. Besides supporting smooth market functioning, asset purchases also
aided in the transmission of monetary policy to broader financial conditions.
Financial markets stabilized relatively quickly. Over the course of 2020, the
Fed's liquidity and credit facilities saw reduced demand and most of the emergency
in a manner that depresses the real interest rate required to equilibrate savings and investment. For
example, lower trend economic growth likely lowers aggregate investment, while demographic factors such
as an increase in life expectancy may increase savings. Other research has emphasized an increase in
demand for safe assets among emerging market economies, which depresses interest rates in advanced
economies. For a review and references, see Michael Kiley (2020), "The Global Equilibrium Real Interest
Rate: Concepts, Estimates, and Challenges," Annual Review of Financial Economics, vol. 12 (1), pp. 305-
26.
3
Supported by funds provided by the CARES Act, the Federal Reserve created, with the authorization of
the U.S. Treasury Department, a number of emergency lending facilities. The extraordinary 'dash for cash'
early in the pandemic threatened the orderly functioning of money markets as well as the flow of credit to
employers. The Board responded with a set of emergency lending facilities that, collectively supported the
flow of credit throughout the economy both by providing backstops and, in some cases, by more directly
supplying funding. Future downturns are unlikely to see the same global, sharp, and intense demand for
liquidity, and thus not warrant the same kind of emergency lending. For more details on the Fed's facilities
to support households, businesses, and municipalities during the COVID crisis see the November 2020
Financial Stability Report at Financial Stability Report (federalreserve.gov)
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programs were decommissioned around year end. Perhaps the most straightforward
takeaway for monetary policy is that in times of severe stress, lending facilities, along
with sharp cuts to the federal funds rate and the introduction of large-scale asset
purchases, are very effective in reviving the economy.
There are some other lessons, I think, from the experience of tightening monetary
policy, a process which was put in motion by the guidance that the FOMC issued in 2020
about how long it would keep the federal funds rate at the effective lower bound and
continue asset purchases. In September and December of 2020, the FOMC provided
criteria or conditions in the meeting statement that would need to be met before the
FOMC would consider raising interest rates and begin to reduce asset purchases,
respectively. These conditions were, in effect, the FOMC's plan for starting the process
of tightening policy. This guidance was short term, specific to the task of when to tighten
policy in this current cycle, and focused on specific tools.
Let me make an important distinction here. A bit earlier, in August 2020, the
Committee completed a multi-year review of our overall strategy for achieving and
sustaining our economic goals. The strategy statement is very different than the
tightening guidance-it is about longer-run goals, not specific actions related to the
current circumstances. The goals in the strategy statement apply in all economic
circumstances and don't include any details on the settings of policy tools. I mention this
distinction because some have argued that the FOMC's new strategy was a factor that led
the Committee to wait too long to begin tightening monetary policy. A bit later, I will
explain why I do not believe this is the case, and I will explain how the guidance for
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tightening policy, laid out in the FOMC's post-meeting statements, was the basis for our
decisions.
So, let's think about how the economy evolved and how the criteria for that
guidance steered the path of policy. In early 2021, the Committee began noting whether
the economy was making progress toward our employment and inflation goals, and thus
getting closer to decisions on unwinding our highly accommodative policy. Based on
our positive experience with unwinding after the Global Financial Crisis (GFC), we
thought it would be appropriate to use the same sequence of steps: taper asset purchases
until they ceased, then lift rates off the effective lower bound, then gradually and
passively reduce our balance sheet by redeeming maturing securities. Most importantly,
through various communications, we made it clear that tapering of asset purchases would
have to be completed before rate liftoff to avoid the conflict that would occur by easing
via continuing asset purchases versus tightening through rate hikes.
In the previous episode of tightening policy after extraordinary accommodation,
this process was very gradual. Tapering of asset purchases took 11 months, and then the
first rate hike did not occur until more than a year after purchases ended. Balance sheet
reduction began more than a year and half after that. This gradualism worked well then,
and it surely influenced the Committee's approach this time.
Implementing this approach required two pieces of guidance: first, criteria for
beginning the tapering process, and, second, criteria to begin raising the policy rate from
the effective lower bound. Through explicit language in FOMC statements, we told the
public the necessary conditions that needed to be met before we would adjust these two
policies.
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For asset purchases, the Committee declared that tapering would wait "until
substantial further progress has been made toward the Committee's maximum
employment and price stability goals."4 Meanwhile, the FOMC said that it would keep
rates near zero until our employment goal had been reached and until inflation had
reached 2 percent and was "on track to moderately exceed 2 percent for some time."5
A fair question is: what did these words mean? And, in particular, what did the
phrases "substantial further progress" for tapering and "for some time" for liftoff mean?
In large part the interpretation hinged on how the Committee viewed the economy would
recover from the pandemic. Looking across forecasts at the time by Committee
participants and the private sector, no one expected substantial progress toward both our
goals to happen very soon. The economy had begun the recover, but at the end of 2020
COVID was bad and getting worse and vaccines were just arriving, so we didn't know
how soon schools would reopen and people would get back to work. In November and
December 2020, the unemployment rate was 6.7 percent and inflation seemed to be in
check: 12-month personal consumption expenditures inflation was declining, and core
inflation, which excludes volatile energy and food prices, was more or less steady at 1.5
percent. The Summary of Economic Projections by FOMC participants in December
2020 had the unemployment rate moving down to 4.2 percent at the end of 2022 and
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inflation moving up to 2 percent only in 2023. Only one participant had liftoff occurring
by the end of 2022.
Based on this SEP, the Committee did not expect the economy to recover quickly.
And, looking at the Federal Reserve Bank of New York's Survey of Primary Dealers
back in January of 2021, the median respondent thought tapering would start in the first
quarter of 2022 and liftoff wouldn't be until the end of 2023 or later.
To move forward, policymakers had to evaluate "substantial further progress" and
"for some time." The phrases, admittedly, are not concrete in their meaning. Inflation
averaging doesn't define how much above 2 percent is moderate and how long some
value of elevated inflation should be tolerated. In addition, for assessing progress on the
health of the labor market, different policymakers will prefer different measures that may
not provide the exact same signal. On top of this, the data used to measure progress in
the labor market can revise substantially and reshape the evaluation of the strength of this
market quite quickly. For example, a key input-payroll data-in the latter half of 2021
painted a picture of a slowing labor market. But revised data over several subsequent
months revealed that the slowdown never happened. Instead, job gains were quite robust.
In particular, initial reports of job creation between August and December were a
cumulative 1.4 million, but by February of this year that number was revised up to nearly
2.9 million.
Overall, the economy evolved rapidly in 2021. I won't get into the month-by-
month details, as I have in recent speeches, but by October and November, policymakers
thought the economy had improved enough to meet the criteria to start tapering at the
early November meeting. Then, later that month, data indicated inflation was
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accelerating, so the Committee hastened the pace of tapering at the December meeting,
making a plan to wind down purchases by early March. Between December and March
of this year inflation data came in very elevated, and at that point there was no question
that inflation had been above 2 percent for "some time." Given continued improvement
in the labor market and the high inflation readings, the Committee began raising interest
rates in March, as soon as asset purchases were completed.
With these actions in the rearview mirror, we can now ask: knowing what we
know now, should we have done anything differently? To be clear, by asking this
question my intent is not to criticize the decisions of the Committee. Rather, it is to
assess our policy strategies should we be confronted with another crisis in the future.
One question to ask is whether the guidance we issued was too "restrictive"; in
other words, did it allow enough flexibility for the FOMC to begin raising the policy rate
when it was appropriate to? Recall, we had decided that raising the policy rate would not
occur until the tapering of asset purchases had finished. But to finish, tapering must
start-for a given pace of tapering, the longer it takes to start tapering, the longer it will
be before the policy rate can be raised. Of course, one can keep the liftoff date fixed and
simply taper at a much faster rate, including the possibility of a hard stop of asset
purchases. But concerns about financial market functioning, including the ability of
markets to absorb the purchases the Fed stops making, typically limits how fast the
tapering can be, particularly given the amount of asset purchases we were making at the
time ($120 billion per month).
Given the tapering criteria and subsequent data, we ultimately had to pivot hard to
accelerate the tapering pace and, in fact, completed the tapering of purchases just a few
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days before we lifted off. Unlike the normalization timeline after the financial crisis, we
did not have flexibility to raise the target range sooner. However, if we had less
restrictive tapering criteria and had started tapering sooner, the Committee could have
had more flexibility on when to begin raising rates.6 So, by requiring substantial further
progress toward maximum employment to even begin the process of tightening policy,
one might argue that it locked the Committee into holding the policy rate at the zero
lower bound longer than was optimal.
My takeaway is that a less restrictive tapering criteria would have allowed more
flexibility to taper "sooner and gradually,' as opposed to the relatively "later and faster"
approach that occurred. Experience has shown that markets need time to adjust to a turn
from accommodation to tightening, and that surely was a factor for FOMC statements
over the years in framing criteria for key policy actions during the recovery from the
GFC and the pandemic. So, I'm supportive of issuing such criteria but we need to be
careful to use language that allows the Committee the flexibility it needs to respond to
changing economic and financial conditions.
Now let's turn to the liftoff criteria. It was also quite restrictive. The liftoff
criteria required the economy to be in a situation where our dual mandate had been
achieved. It can be argued that this meant getting the economy back to its 2019 state with
very low unemployment and inflation near 2 percent. But the policy rate in 2019 was
well above zero and close to its neutral value. Consequently, if the state of the economy
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is telling you to be at neutral and you are at zero, then any Taylor rule would say the
policy rate needs to rise much faster than was typically done in the past.
So, it should not have been a surprise that the policy rate would rise fast in 2022.
Rate hikes would need to be larger and more frequent, relative to the 2015-2018
tightening pace, to get back to neutral. Looking back, should the Committee have
signaled a steeper rate path once the liftoff criteria had been met? Perhaps another lesson
is that giving forward guidance about liftoff should also include forward guidance about
the possible path of the policy rate after liftoff.
In closing, I hope that our country is not faced with another crisis as severe as the
one precipitated by COVID, and that the Fed is not faced with the challenges of setting
monetary policy under such conditions. But if we again face those challenges, we now
have the additional insight that only experience can bring. I hope that this latest
experience will help us approach the future with a more complete understanding of the
policy choices and tradeoffs.