From interest rate cuts to the new framework of the Fed's monetary policy

On August 22 this year, Fed Chairman Powell delivered an opening speech at the Jackson Hole Central Bank Conference. The first half of his speech analyzed the current economic situation, suggesting a rate cut in September, which is the focus of the market. The second half of his speech introduced the newly revised monetary policy framework, but this part of the speech did not attract much attention from the market.

The Fed publicly outlined its monetary policy goals and framework starting in 2012, which was also the first year the Fed adopted an inflation targeting system. According to regulations, this framework is revised every five years, and the currently adopted framework must be "declared" annually, which refers to the FOMC's (Federal Open Market Committee) annual "Statement on Long-Term Goals and Monetary Policy." There are two reasons for the annual "repeated" declaration within the same revision cycle: first, to enhance the credibility of the Fed as an institution and to show that it "remains true to its original mission." The second reason is that this statement is known internally at the Fed as the "Consensus Statement," which is drafted with the participation of all 19 FOMC members (12 of whom vote at each meeting), and everyone ultimately agrees on the wording. This consensus on policy goals and methodologies promotes collective decision-making and strengthens the members' self-restraint (after all, the policy goals and methodologies are agreed upon by everyone), and the repeated declaration serves as a "reminder" for the members.

The Changes and Constants in the New "Consensus"

The first paragraph of the 2025 Consensus Statement discusses the mission of the Fed and the importance of increasing transparency, continuing the wording from 2024.

The second paragraph discusses the economic mechanisms behind the deviations of inflation and employment from the mission targets, as well as the basic policy tools to promote the achievement of these targets. The 2025 statement introduces an important addition to the second paragraph: "The committee's monetary policy tools need to achieve the missions of employment and inflation in a broad economic environment." This paragraph can be seen as a reflection on the 2020 framework. During the period from 2012 to 2019, the U.S. economy experienced long-term low inflation (the average core PCE inflation rate was 1.4%), and the unemployment rate was relatively high before 2016. Therefore, the Fed's greatest concern was the entrenchment of a long-term low inflation and low interest rate environment, which could lead to the ELB (effective lower bound) problem—an excessively low normal policy interest rate that lacks room for cuts in the face of economic downturns. The 2020 policy design was aimed at addressing the dominant conditions mentioned above. After the second half of 2021, the Fed found that this overly targeted strategy had significant limitations, responding too slowly when inflation unexpectedly surged, and this reflection led to the consensus statement regarding the aforementioned changes.

The second paragraph of the 2020 version of the statement uses considerable space to discuss the decline of the natural rate, the constraints faced by the Fed due to the effective lower bound on interest rates, and the Fed's basic judgment at that time regarding the increasing downside risks to employment and inflation. By 2025, these discussions were simplified to "If the policy interest rate is constrained by the effective lower bound, the Fed will use all available tools (to overcome this)," indicating that the new version significantly downplayed the severity of the ELB. It is not difficult to understand that this shift stems from the experience of high inflation since 2021.

The third section is about the employment mandate. Both versions agree that "the level of full employment is constantly changing due to many factors, and therefore the Committee does not set a fixed target." However, the 2025 version adds that "the Committee believes that the maximum employment is the highest level of employment that can be achieved under price stability." In contrast, the 2020 version does not provide such a clear definition of full employment, instead vaguely indicating the use of various indicators to assess full employment. Accordingly, the employment goal in the 2025 policy statement directly targets full employment and is symmetrical, meaning that whether actual employment is above or below the level of full employment, monetary policy needs to change. In contrast, the 2020 version only responds to employment shortfall; if the employment level is above full employment, then monetary policy does not adjust. This is a significant change, largely due to the high inflation in recent years exceeding the Fed's expectations.

The 2020 version meant that at that time the Fed believed the Phillips curve was flat, and lower unemployment would not lead to high inflation, thus tending to let the labor market "overheat". In 2021, the Fed implemented this strategy. Although the anticipated inflation in 2022 put the Fed in a passive position, this way of doing things according to established rules reflected the credibility of the Fed's statements. A loss on one front is a gain on another; this credibility is largely the main reason for the U.S. economy achieving a soft landing during the 2022-2024 period.

Regarding the mission of price stability, both versions of the statement confirm that long-term inflation depends on monetary policy, and therefore the Fed needs to be responsible for price stability. Both versions of the statement confirm 2% as the inflation target and emphasize the importance of maintaining a 2% long-term inflation expectation. The difference is that the 2020 version of the statement states, "The Committee's objective is to achieve an average inflation target of 2%; if actual average inflation remains below 2% for some time, then the subsequent period will seek an inflation target above 2% (as compensation for the earlier low inflation)." The 2025 statement, however, has undergone significant changes, with the target set at 2%, no longer an average of 2%. The implication of this change is that if past inflation was below 2%, future policy will not pursue high inflation as a means of "compensation."

The consensus statements of the old and new versions have not changed the discussion on risk balance. The methodology of risk balance is the main basis for Powell's communication with the market during the interest rate cut in September.

Transition between Old and New Frameworks: Further Discussion

In a 2025 internal seminar at the Fed, Powell reviewed the context in which the framework was introduced in 2020. In addition to the reasons discussed above, he also talked about the promoting effect of the increasingly deepening globalization on the low inflation in the United States at that time. The long experience of low inflation has had a profound impact on the mindset of Fed decision-makers.

At the same seminar, Professor Carl Walsh from the University of California also gave an important speech, pointing out that another reason for the Fed's "inflation targeting framework" in 2020 might be the "mistake" of raising interest rates too early in 2015. The rate hike cycle that began at the end of that year progressed more slowly than expected, with only one hike in both 2015 and 2016. By the end of 2018, there was significant downward economic pressure, leading the Fed to start cutting rates in 2019. The benefit of an average inflation target is that it can raise market inflation expectations, while monetary policy becomes somewhat sticky as it is based on past average inflation. Focusing monetary policy on employment gap targets can lead to an overheating economy, thus providing advantages in a low inflation environment.

One shortcoming of the 2020 version is that the Fed's commitment to a 2% long-term inflation target may no longer be credible, as the public may find it difficult to understand the exact meaning of average inflation. Suppose the current inflation rate is 4%, but the Fed does not tighten monetary policy because it wants to compensate for past low inflation. At this point, the public may linearly extrapolate to form inflation expectations, resulting in inflation expectations of 4% or higher, rather than the 2% intended by policy. Additionally, the average inflation targeting framework is not clear enough; the calculation window for the average is not explicitly defined by the Fed as being 3 years, 5 years, or 8 years. After the 2025 new version restores a flexible inflation targeting framework, the aforementioned difficulties will no longer exist. The consensus of the Fed in the 2020 version did not clearly define what constitutes full employment, making this mission less clear. The 2025 new version clarifies this.

Whether it is the new framework or the old framework, the policy framework of the Fed in the past decade has demonstrated the comprehensive application of New Keynesian macroeconomics in monetary policy, which has become increasingly mature. The central banks before Greenspan were mysterious, overseeing the entire macroeconomy from a high vantage point, then silently intervening to regulate the economy. The Fed after Greenspan, under the leadership of two top academic macroeconomists, has deeply integrated rational expectations, dynamic equilibrium, and open policy intentions into its systemic framework. Looking back, this is a significant change.

The Independence, Transparency, and Source of Power of the Fed

Former Chairman Bernanke also participated in the seminar in May and gave a keynote speech, discussing the reasons and specific tools for further improving the transparency of Fed policies. Bernanke suggested that the Fed's research department publicly release analyses and forecasts regarding major possible economic scenarios (risks), and recommended that the FOMC depict more economic scenarios in various communication tools, explaining the monetary policy responses for each scenario, thereby conveying more risk "awareness" to the public through multi-scenario discussions. Additionally, Bernanke suggested providing more textual descriptions for the SEP (Summary of Economic Projections).

Interestingly, the senior officials of the Fed almost unanimously opposed the "old leader"'s suggestion. Waller refuted it by citing the 2023 Silicon Valley Bank crisis as an example. At that time, the research team and the committee had significant differences in opinions. Waller pointed out that if the researchers' predictions were published, the governance structure of the Fed could be affected (he meant that the researchers would indirectly gain some power from the FOMC). The most interesting scene came from the debate between Bernanke and the discussant. The discussant from Yale University opposed Bernanke's entire plan, citing that if the researchers' predictions differed too much from the FOMC's views, he wouldn't know how to explain it to the market. Bernanke quickly countered, "Unfortunately, this has never happened." The discussant rebutted that it had happened, citing that in the mid-1990s, the Fed's research team was worried about inflation, but Greenspan opposed it, believing that productivity growth would offset inflationary pressures. Bernanke further rebutted, "But at that time, the entire FOMC committee highly agreed with the research team's views," and then added, "But they were wrong." This last statement referred to Greenspan's proud achievement at that time (when he resisted the majority and did not raise interest rates, which later proved to be correct), and it could also be seen as a self-deprecating remark about the FOMC at that time, which evoked laughter from the attendees (but Bernanke himself remained calm throughout).

Bernanke's advocacy for greater transparency is of significant importance, especially in the current context where the independence of the Fed is under threat. In places where expression is free, power derives from the weight of reasoned argument. If the level of discourse is insufficient, then the authority is limited, meaning the power is not substantial. During Bernanke's seminar, there was a branch president who had not been trained in macroeconomics; he used a more common example to refute Bernanke's claims, but clearly, his concepts were somewhat off-topic and his logic was not very coherent. Bernanke did not respond to this.

Yellen is a different case. When she first joined the Fed as a governor, she "pressed" Greenspan in a meeting: what is your desired inflation target, can you give a number? After hesitating for a long time, Greenspan stated that he thought 2% was appropriate. This dialogue is regarded as a precursor to the Fed's shift towards an inflation targeting regime. At that time, Yellen was not yet well-known, being a newcomer in Washington, but she challenged Greenspan with her knowledge.

Recently, Trump has been constantly trying to "insert his people" into the Fed, and the independence of the Fed seems to be on shaky ground. FOMC members all have to participate in the "consensus statement," which, in my opinion, is an important part of maintaining the independence of the Fed. If a member goes against his own consensus statement during a monetary policy meeting, others will rebut him, and in a group that highly values "intellectual excellence," this can be very "humiliating." There are eight FOMC meetings a year, and if each time they are "humiliated" like this, it will indeed create quite a bit of pressure.

Institutional economists have made little profound progress on the issue of how institutions can be effective (that is, from textual to actual constraints), mainly because they have abandoned (or failed to understand) Commons' important concept that institutions are the collective coercion of individuals. The author believes that this concept is as crucial for understanding institutions as effective demand is for macroeconomics, and liquidity preference is for monetary economics; they are invisible and intangible but exist there in a real and eternal way. The "gene" mechanism through which institutions operate, in the author's view, cannot be found without Commons' insights, as that is the essence. For example, the gene code for the effectiveness of the Fed's "consensus statement" is as follows: if a consensus statement on monetary policy is abandoned, and only the FOMC members who obey the White House are listened to, during debates, they will be "humiliated" by other members, and the member in question is bound to feel guilty and short of breath (in stark contrast to the above-mentioned Yellen boldly challenging Greenspan), this is the collective coercion of the individual. This is how the Fed's independence from the White House as an institution (one of them) comes into effect. How collective coercion of the individual is formed is also the gene code for analyzing power. Mysticism and ignorance are often linked, while disenchantment and enlightenment progress are closely connected. The author believes that Commons is the one who helps in disenchantment.

The first time I read about Kahn's work in my youth, I was ecstatic; something I had always sensed but could not articulate was expressed so easily, concisely, and accurately by him. I remember laughing heartily and slapping the railing at that moment. A public commitment is binding; language is power. Now, with the insights of Kahn's system, my confidence in the Fed's independence has increased, and the theory of the dollar's collapse can be dismissed.