For release on delivery
3:00 p.m. EST (Noon PST)
January 13, 2021
The Federal Reserve's New Framework: Context and Consequences
Remarks by
Richard H. Clarida
Vice Chair
Board of Governors of the Federal Reserve System
at
"The Road Ahead for Central Banks," a seminar sponsored by
the Hoover Economic Policy Working Group
Hoover Institution
Stanford University
Stanford, California
(via webcast)
January 13, 2021
On August 27, 2020, the Federal Open Market Committee (FOMC) unanimously
approved a revised Statement on Longer-Run Goals and Monetary Policy Strategy, which
represents a robust evolution of its monetary policy framework.1 At its September and
December FOMC meetings, the Committee made material changes to its forward
guidance to bring it into line with the new policy framework.2 Before I discuss the new
framework in detail and the policy implications that flow from it, please allow me to
provide some background on the reasons the Committee felt that our framework needed
to evolve.
Motivation for the Review
As my FOMC colleagues and I indicated from the outset, the fact that the Federal
Reserve System chose to conduct this review does not indicate that we believed we were
poorly served by the framework in place since 2012.3 Indeed, I would argue that over the
past eight years, the framework served us well and supported the Federal Reserve's
efforts after the Global Financial Crisis (GFC) first to achieve and then, for several years,
to sustain-until cut short this spring by the COVID-19 pandemic-the operation of the
economy at or close to both our statutorily assigned goals of maximum employment and
price stability in what became the longest economic expansion in U.S. history.
Nonetheless, both the U.S. economy-and, equally importantly, our understanding of the
economy-have clearly evolved along several crucial dimensions since 2012, and we
believed that in 2019 it made sense to step back and assess whether, and in what possible
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ways, we might refine and rethink our strategy, tools, and communication practices to
achieve and sustain our goals as consistently and robustly as possible in the global
economy in which we operate today and for the foreseeable future.
Perhaps the most significant change since 2012 in our understanding of the
economy is our reassessment of the neutral real interest rate, r*, that, over the longer run,
is consistent with our maximum-employment and price-stability mandates. In January
2012, the median FOMC participant projected a long-run r* of 2.25 percent, which, in
tandem with the inflation goal of 2 percent, indicated a neutral setting for the federal
funds rate of 4.25 percent. However, in the eight years since 2012, members of the
Committee-as well as outside forecasters and financial market participants-have
repeatedly marked down their estimates of longer-run r* and, thus, the neutral nominal
policy rate. Indeed, as of the most recent Summary of Economic Projections (SEP)
released in December, the median FOMC participant currently projects a longer-run r*
equal to just 0.5 percent, consistent with a neutral setting for the federal funds rate of
2.5 percent.4 Moreover, as is well appreciated, the decline in neutral policy rates since
the GFC is a global phenomenon that is widely expected by forecasters and financial
markets to persist for years to come.
The substantial decline in the neutral policy rate since 2012 has critical
implications for the design, implementation, and communication of Federal Reserve
monetary policy because it leaves the FOMC with less conventional policy space to cut
rates to offset adverse shocks to aggregate demand. With a diminished reservoir of
conventional policy space, it is much more likely than was appreciated in 2012 that, in
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economic downturns, the effective lower bound (ELB) will constrain the ability of the
FOMC to rely solely on the federal funds rate instrument to offset adverse shocks. This
development, in turn, makes it more likely that recessions will impart elevated risks of
more persistent downward pressure on inflation and upward pressure on unemployment
that the Federal Reserve's monetary policy should, in design and implementation, seek to
offset throughout the business cycle and not just in downturns themselves.
Two other, related developments that have also become more evident than they
appeared in 2012 are that price inflation seems less responsive to resource slack, and also,
that estimates of resource slack based on historically estimated price Phillips curve
relationships are less reliable and subject to more material revision than was once
commonly believed. For example, in the face of declining unemployment rates that did
not result in excessive cost-push pressure to price inflation, the median of the
Committee's projections of u*-the rate of unemployment consistent in the longer run
with the 2 percent inflation objective-has been repeatedly revised lower, from
5.5 percent in January 2012 to 4.1 percent as of the December 2020 SEP. Projections of
u* by the Congressional Budget Office and professional forecasters show a similar
decline during this same period and for the same reason. In the past several years of the
previous expansion, declines in the unemployment rate occurred in tandem with a notable
and, to me, welcome increase in real wages that was accompanied by an increase in
labor's share of national income, but not a surge in price inflation to a pace inconsistent
with our price-stability mandate and well-anchored inflation expectations. Indeed, this
pattern of mid-cycle declines in unemployment coincident with noninflationary increases
in real wages has been evident in the U.S. data since the 1990s.
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With regard to inflation expectations, there is broad agreement among academics
and policymakers that achieving price stability on a sustainable basis requires that
inflation expectations be well anchored at the rate of inflation consistent with the price-
stability goal. This is especially true in the world that prevails today, with flat Phillips
curves in which the primary determinant of actual inflation is expected inflation. The
pre-GFC academic literature derived the important result that a credible inflation-
targeting monetary policy strategy that is not constrained by the ELB can deliver, under
rational expectations, inflation expectations that themselves are well anchored at the
inflation target. In other words, absent a binding ELB constraint, a policy that targets
actual inflation in these models delivers long-run inflation expectations well anchored at
the target "for free." But this "copacetic coincidence" no longer holds in a world of low
r* in which adverse aggregate demand shocks are expected to drive the economy in at
least some downturns to the ELB. In this case, which is obviously relevant today,
economic analysis indicates that flexible inflation-targeting monetary policy cannot be
relied on to deliver inflation expectations that are anchored at the target, but instead will
tend to deliver inflation expectations that, in each business cycle, become anchored at a
level below the target. This is the crucial insight in my colleague John Williams's
research with Thomas Mertens. This downward bias in inflation expectations under
inflation targeting in an ELB world can in turn reduce already scarce policy space-
because nominal interest rates reflect both real rates and expected inflation-and it can
open up the risk of the downward spiral in both actual and expected inflation that has
been observed in some other major economies.
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The New Framework and Price Stability
Six features of the new framework and fall 2020 FOMC statements define how
the Committee will seek to achieve its price-stability and maximum-employment
mandates over time. First, the Committee expects to delay liftoff from the ELB until
PCE (personal consumption expenditures) inflation has risen to 2 percent and other
complementary conditions, consistent with achieving this goal on a sustained basis, have
also been met.5
Second, with inflation having run persistently below 2 percent, the Committee
will aim to achieve inflation moderately above 2 percent for some time in the service of
keeping longer-term inflation expectations well anchored at the 2 percent longer-run
goal.6
Third, the Committee expects that appropriate monetary policy will remain
accommodative for some time after the conditions to commence policy normalization
have been met.7
5
The Statement on Longer-Run Goals and Monetary Policy Strategy articulates the inflation objective:
"The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual
change in the price index for personal consumption expenditures, is most consistent over the longer run
with the Federal Reserve's statutory mandate" (paragraph 4). The FOMC statements starting with
September 2020 indicate the conditions for liftoff: "The Committee decided to keep the target range for the
federal funds rate at 0 to 1/4 percent and expects it will be appropriate to maintain this target range until
labor market conditions have reached levels consistent with the Committee's assessments of maximum
employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some
time" (paragraph 4). The statements are available on the Board's website at
https://www.federalreserve.gov/monetarypolicy/fomccalendars.htm.
6
The FOMC statements starting with September 2020 read: "With inflation running persistently below this
longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time so
that inflation averages 2 percent over time and longer-term inflation expectations remain well anchored at
2 percent" (paragraph 4). A similar sentence appears in the Statement on Longer-Run Goals and Monetary
Policy Strategy.
7
The FOMC statements starting with September 2020 read: "The Committee seeks to achieve maximum
employment and inflation at the rate of 2 percent over the longer run. With inflation running persistently
below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for
some time so that inflation averages 2 percent over time and longer-term inflation expectations remain well
anchored at 2 percent. The Committee expects to maintain an accommodative stance of monetary policy
until these outcomes are achieved" (paragraph 4).
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Fourth, policy will aim over time to return inflation to its longer-run goal, which
remains 2 percent, but not below, once the conditions to commence policy normalization
have been met.8
Fifth, inflation that averages 2 percent over time represents an ex ante aspiration
of the FOMC, but not a time-inconsistent ex post commitment.9
As I highlighted in a speech at the Brookings Institution in November, I believe
that a useful way to summarize the framework defined by these five features is temporary
price-level targeting (TPLT, at the ELB) that reverts to flexible inflation targeting (once
the conditions for liftoff have been reached).10 Just such a framework has been analyzed
by Bernanke, Kiley, and Roberts (2019) and Bernanke (2020), who in turn build on
earlier work by Evans (2012), Reifschneider and Williams (2000), and Eggertsson and
Woodford (2003). Each of these five elements of the new framework is consequential. I
now discuss each in turn and provide some context for how I understand them to relate to
the monetary economics literature on TPLT.
A policy that delays liftoff from the ELB until a threshold for average inflation
has been reached is one element of a TPLT strategy. Starting with our September FOMC
statement, we communicated that inflation reaching 2 percent is a necessary condition for
liftoff from the ELB. This condition refers to inflation on an annual basis. TPLT with
such a one-year memory has been studied by Bernanke, Kiley, and Roberts (2019). The
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FOMC also indicated in these statements that the Committee expects to delay liftoff until
inflation is "on track to moderately exceed 2 percent for some time." What "moderately"
and "for some time" mean will depend on the initial conditions at liftoff (just as they do
under other versions of TPLT), and the Committee's judgment on the projected duration
and magnitude of the deviation from the 2 percent inflation goal will be communicated in
the quarterly SEP for inflation.
In the TPLT studies I cited earlier, policy is assumed to revert to an inertial Taylor
rule after liftoff, and therefore policy remains accommodative for some time thereafter,
which depends on the degree of policy inertia in the reaction function. Our three most
recent FOMC statements also call for policy to remain accommodative for some time
after liftoff, and, once the conditions to commence policy normalization have been met,
the SEP "dot plot" will convey the Committee's projections for the pace of liftoff as well
as the ultimate destination for the policy rate.
Our new framework is asymmetric. That is, as in the previously cited TPLT
studies, the goal of monetary policy after lifting off from the ELB is to return inflation to
its 2 percent longer-run goal, but not to push inflation below 2 percent. In the case of the
Federal Reserve, we have highlighted that making sure that inflation expectations remain
anchored at our 2 percent objective is just such a consideration. Speaking for myself, I
follow closely the Fed staff's index of common inflation expectations (CIE) as a relevant
indicator that this goal is being met (see the figure).11 Other things being equal, my
desired pace of policy normalization post-liftoff to return inflation to 2 percent-as well
as the projected pace of return to 2 percent inflation-would be somewhat slower than
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otherwise if the CIE index is, at time of liftoff, below the pre-ELB level. Another factor I
will consider in calibrating the pace of policy normalization post-liftoff is the average
rate of PCE inflation since the new framework was adopted in August 2020-a time, as it
happened, when the federal funds rate was constrained at the ELB.
Our framework aims ex ante for inflation to average 2 percent over time, but it
does not make a (time-inconsistent) commitment to achieve ex post inflation outcomes
that average 2 percent under any and all circumstances. The same is true for the TPLT
studies I cited earlier. In these studies, the only way in which average inflation enters the
policy rule is through the timing of liftoff itself. Yet in stochastic simulations of the
FRB/US model under TPLT with a one-year memory that reverts to flexible inflation
targeting after liftoff, inflation does average very close to 2 percent (see the table). The
model of Mertens and Williams (2019) delivers a similar outcome: Even though the
policy reaction function in their model does not incorporate an ex post makeup element,
it delivers a long-run (unconditional) average rate of inflation equal to target by aiming
for a moderate inflation overshoot away from the ELB that is calibrated to offset the
inflation shortfall caused by the ELB.
The New Framework and Maximum Employment
Regarding our maximum-employment mandate-a sixth element-an important
evolution in our new framework is that the Committee now defines maximum
employment as the highest level of employment that does not generate sustained
pressures that put the price-stability mandate at risk.12 As a practical matter, this
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definition means to me that when the unemployment rate is elevated relative to my SEP
forecast of its long-run natural level, monetary policy should, as before, continue to be
calibrated to eliminate such employment shortfalls so long as doing so does not put the
price-stability mandate at risk. Indeed, in our September and subsequent FOMC
statements, we indicated that we expect it will be appropriate to keep the federal funds
rate in the current 0 to 25 basis point target range until inflation has reached 2 percent (on
an annual basis) and labor market conditions have reached levels consistent with the
Committee's assessment of maximum employment. In our new framework, when in a
business cycle expansion labor market indicators return to a range that, in the
Committee's judgment, is broadly consistent with its maximum-employment mandate, it
will be data on inflation itself that policy will react to, but going forward, policy will not
tighten solely because the unemployment rate has fallen below any particular
econometric estimate of its long-run natural level. This guidance has an important
implication for the Taylor-type policy reaction function I will consult. Consistent with
our new framework, the relevant policy rule benchmark I will consult once the conditions
for liftoff have been met is an inertial Taylor-type rule with a coefficient of zero on the
unemployment gap, a coefficient of 1.5 on the gap between core PCE inflation and the
2 percent longer-run goal, and a neutral real policy rate equal to my SEP forecast of long-
run r*. Such a reference rule, which becomes relevant once the conditions for policy
normalization have been met, is similar to the forward-looking Taylor-type rule for
optimal monetary policy derived in Clarida, Galí, and Gertler (1999).
Concluding Remarks
In closing, I think of our new flexible average inflation-targeting framework as a
combination of TPLT at the ELB with flexible inflation targeting, to which TPLT reverts
once the conditions to commence policy normalization articulated in our most recent
FOMC statement have been met. In this sense, our new framework indeed represents an
evolution, not a revolution. Thank you very much, and I now look forward-as always-
to the discussion with the participants in this virtual Hoover event.
References
Ahn, Hie Joo, and Chad Fulton (2020). "Index of Common Inflation Expectations,"
FEDS Notes. Washington: Board of Governors of the Federal Reserve System,
September 2, https://doi.org/10.17016/2380-7172.2551.
Bernanke, Ben S. (2020). "The New Tools of Monetary Policy," American Economic
Review, vol. 110 (April), pp. 943-83.
Bernanke, Ben S., Michael T. Kiley, and John M. Roberts (2019). "Monetary Policy
Strategies for a Low-Rate Environment," AEA Papers and Proceedings, vol. 109
(May), pp. 421-26.
Clarida, Richard H. (2020a). "The Federal Reserve's New Monetary Policy Framework:
A Robust Evolution," speech delivered at the Peterson Institute for International
Economics, Washington (via webcast), August 31,
https://www.federalreserve.gov/newsevents/speech/clarida20200831a.htm.
--- (2020b). "The Federal Reserve's New Framework: Context and Consequences,"
speech delivered at "The Economy and Monetary Policy," an event hosted by the
Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution,
Washington (via webcast), November 16,
https://www.federalreserve.gov/newsevents/speech/clarida20201116a.htm.
Clarida, Richard H., Jordi Galí, and Mark Gertler (1999). "The Science of Monetary
Policy: A New Keynesian Perspective," Journal of Economic Literature, vol. 37
(December), pp. 1661-707.
Eggertsson, Gauti B., and Michael Woodford (2003). "The Zero Bound on Interest Rates
and Optimal Monetary Policy," Brookings Papers on Economic Activity, no. 1,
pp. 139-233,
https://www.brookings.edu/wpcontent/uploads/2003/01/2003a_bpea_eggertsson.pdf.
Evans, Charles L. (2012). "Monetary Policy in a Low-Inflation Environment:
Developing a State-Contingent Price-Level Target," Journal of Money, Credit
and Banking, vol. 44 (February, S1), pp. 147-55.
Mertens, Thomas M., and John C. Williams (2019). "Tying Down the Anchor:
Monetary Policy Rules and the Lower Bound on Interest Rates," Staff Report 887.
New York: Federal Reserve Bank of New York, May (revised August 2019),
https://www.newyorkfed.org/research/staff_reports/sr887.html.
Reifschneider, David L., and John C. Williams (2000). "Three Lessons for Monetary
Policy in a Low-Inflation Era," Journal of Money, Credit and Banking, vol. 32
(November), pp. 936-66.
Stochastic Simulation Result of FRB/US Model
under Model-Consistent Expectations
ELB
Mean duration
Mean Mean RMSD of RMSD of
of ELB
frequency Loss
output gap inflation rate output gap inflation rate
(quarters)
(percent)
1. Taylor 38.3 10.9 -1.1 1.2 3.5 2.2 17.2
2. Taylor (inertial) 33.6 20.7 -1.4 1.0 3.9 2.4 20.7
3. Flexible price-level target 32.6 8.5 -.4 2.0 3.6 1.5 15.2
4. Flexible price-level target (inertial) 24.6 13.8 -.6 2.0 4.4 1.5 21.8
5. Flexible temporary price-level target 17.6 12.9 .3 2.4 3.4 1.6 14.5
6. Temporary price-level target 16.3 12.5 .0 2.3 3.1 1.7 12.6
7. Temporary price-level target (3-yr. memory) 15.6 11.2 .3 2.4 2.7 1.6 9.6
8. Temporary price-level target (1-yr. memory) 15.1 9.4 .2 2.3 2.5 1.5 8.5
9. Reifschneider-Williams 28.1 10.1 .2 2.1 2.4 1.6 8.0
10. Kiley-Roberts change rule 37.0 16.9 -.1 2.1 1.9 1.4 5.7
2
1 1 2
KK NN
-
ππ∗ +
∑ ππtt,jj yytt,jj 
LLLLLLLL = ∑ tt=1
Note: Results based on 500 simulations of 100 quarters each. jj=1 for t, j period-simulations.
NN KK
FRB/US is the Federal Reserve's principal simulation model; ELB is effective lower bound; RMSD is root mean square deviation.
Source: Bernanke, Kiley, and Roberts (2019).
Estimated Index of Common Inflation Expectations
(projected onto SPF 10-year-ahead PCE inflation expectations)
Note: The shaded area denotes a 95% confidence interval. The horizontal dotted line is marked at 2%. SPF is Survey of
Professional Forecasters; PCE is personal consumption expenditures; CIE is common inflation expectations.
Source: Ahn and Fulton (2020).