US economy: the Federal Reserve’s reality check
In October, Jay Powell hosted guests at the Federal Reserve’s Marriner Eccles building in Washington. They sat at the boardroom table where the Fed’s Open Market Committee makes its decisions about interest rates and the Fed’s balance sheet. Silk-walled and chandeliered, the room served as a secure meeting place for UK and US military staff during the second world war.
After several hours of conversation, Mr Powell, chair of the Fed’s board of governors since February 2018, said: “We think our inflation is a little bit lower than we’d like it to be. But we realise for many people that sounds a little bit crazy.”
He explained to his guests — representatives of non-profits, community groups and small businesses — that if inflation falls too far, the Fed loses its power to encourage banks to lend more. Then, smiling a bit, he asked them: “Do you have any ideas on how to explain that to the public?”
The guests broke into laughter. “I think you’re going to need another three hours for that,” said one.
This summer, the Fed will release the results of an 18-month review of how it carries out and talks about monetary policy. While President Donald Trump has badgered the central bank to lower rates, the bank itself has been discussing something more fundamental: the tools at its disposal. As part of that review, Fed staff organised 14 “Fed Listens” events, where they invited business and community leaders at least once to every regional Fed bank and the board of governors in Washington.
Mr Powell came to several of these events, and seemed to enjoy them — asking questions and taking notes. Over the past year the FOMC has lowered its policy rate three times by a total of 75 basis points, and indicated that it has no plans in 2020 to raise them again. The Fed eased for several reasons: it was concerned about a slowdown abroad and a lack of inflation at home. It also appears to have paid attention at its Fed Listens events.
Two messages came through in particular from the events. First, there is more “slack” than the Fed had thought — more people who could still come into the labour force, particularly in poorer areas. Second, most Americans are more worried about increases in the cost of housing and medical care than they are about low overall inflation. Unlike the Fed, in fact, Americans do not seem to be worried about low inflation at all.
The meetings took place at a time the Fed has been rethinking the nature of the post-crisis economy. Evidence from the Fed Listens events has also crept into the standardised language that Mr Powell and his vice-chair, Richard Clarida, use to describe the state of the economy. That language, in turn, sends a signal to markets about future path of interest rates. This means that long before the Fed finishes its review, the events have already become a tool for the Fed’s “forward guidance” — hints about what’s coming in monetary policy.
“People who live and work in low- and middle-income communities tell us that many who have struggled to find work are now finding new opportunities,” Mr Powell said at his press conference in December. “These developments underscore for us the importance of sustaining the expansion so that the strong job market reaches more of those left behind.”
After the laughter died down in the Fed boardroom, Denise Scott, from the Local Initiatives Support Corporation, a non-profit that identifies investments in poorer areas, agreed with Mr Powell’s point — that higher inflation would help to stimulate growth in the long run.
“But for many of our communities, the distance to the long term, we don’t — we just don’t survive that, that’s part of the problem,” she said. “The business closes. People don’t get to make the choice, say, for higher education. Families just can’t buy the milk today. I think that’s the challenge.”
All of the Fed’s monetary tools are intended to work on the same basic principle: to create economic growth, the central bank pushes down rates for a time, making loans more attractive. For the last several years, though, the Fed has been increasingly worried about the effectiveness of its tools.
The “natural rate” — an estimate by the New York Fed of what commercial interest would be without any central bank action — has been dropping steadily for years. The Fed cannot undercut something that is already on the floor.
Another way to accomplish the same thing would be to generate more inflation, reducing inflation-adjusted interest rates. But that’s been dropping, too. Since the Fed set its inflation target of 2 per cent in 2012, it has only reached it once, in the summer of 2018.
The Fed has a ritualised process for gathering data before its policy meetings, but the Fed Listens events have already begun to supplement this process and help define new areas of policy research. And according to the minutes of the Fed’s December meeting, some policymakers said they would like the events to continue, something Mr Powell has also suggested will happen.
What could have been a feel-good part of a one-time review, then, has become a serious research habit.
“The individual reserve banks will continue to do these type of events,” says Robert Kaplan, president of the Dallas Fed. “But I think it’s a good thing for the Fed in a more formal, organised way to be doing these Fed listens events on some regular basis.”
“I’ve been pleasantly surprised at how meaningful they were,” Neel Kashkari, president of the Minneapolis Fed, says.
It’s not quite fair to say the Fed had never encountered regular people before. As well as running a nonprofit group, since early 2019 Ms Scott has served as chair of the New York Fed’s board of directors. But there are two novelties about her conversation with Mr Powell. First, it took place not at a regional Fed bank but in the boardroom of the Eccles building, in front of three governors. Second, they were not talking about how to boost local community development. They were talking about the policy decisions of the Fed’s rate-setting committee.
“There’s always been an aspect of the Federal Reserve that has been tied to community,” says Claudia Sahm of the Washington Center for Equitable Growth. “It has not ever been a part of monetary policy.”
The Federal Reserve has several jobs. It carries out monetary policy. Like the Bank of England, the Bank of Japan or the European Central Bank, the Fed has to keep prices stable. Uniquely among them, however, it’s also required to pursue “maximum employment” — it defines this as making sure that anyone who wants a job can get one, hence the focus on slack in the US economy.
The Fed also makes sure that banks are lending without prejudice and to encourage growth within their own cities, a function it calls “community development.”
The trained economists at the Fed have tended to stay cloistered in their own departments, separating the macroeconomics research that guides monetary policy decisions from work on community development. Ms Sahm, who ran consumer and community research at the Fed’s board of governors until October of last year, says the community development research staff had seen early warnings of the financial crisis, but did not know how to package what they had seen for policymakers.
“They had absolutely no way to convey that to the FOMC. And [former Fed chair Alan] Greenspan didn’t want to hear anything about it,” she says. “How do you take a thousand anecdotes and turn it into a boardroom briefing?”
Ms Sahm says the Fed Listens events, and Mr Powell’s commitment to them, had sent a signal to the career research staff, mostly PhD macroeconomists, about what is important. “Economists don’t trust anecdotes,” she says. “But anecdotes can also spawn an, ‘Oh, I should look at that in the data.’”
At the Fed’s December meeting, for example, as part of a presentation on findings from the events, Fed research staff presented results from a model that incorporates “heterogeneity” — the possibility that the same economy has different effects on different people. In the model, the assumption that some people cannot borrow money produced sharper downturns, particularly when the policy rate is already close to zero.
“What’s new now is attempting to hear from these voices in a way that’s more directly related to the monetary policy front lines,” says David Wilcox of the Peterson Institute for International Economics. “The division of community affairs was hearing from these voices, but it was one step removed from the monetary policy process.”
Mr Wilcox ran the research and statistics division at the board of governors from 2011 to 2018. He says stories, often underestimated by macroeconomists, are important, because policymakers do not make decisions in a simplified, graduate-school environment.
“Decisions are made under profound uncertainty”, he says, “and if you better understand the consequences, you’ll better understand the risks.”
The Fed does its work within a complex institutional arrangement, an early 20th-century compromise to pacify southern and western US banks that were reluctant to let anyone back east tell them how many loans they could make. A central bank in all but name, the Federal Reserve System balances the Washington-based board of governors, appointed by the White House, with 12 regional Fed banks, each controlled in part by commercial banks in their own districts.
Contact with local workers and businesses has tended to take place through the regional Feds, whose presidents keep a regular schedule of meetings and speeches with business and civic groups. Regional Fed research staff also compile a quarterly Beige Book, a record of conversations, mostly with business leaders.
More recently, Fed bank presidents had begun taking the board of governors for visits to poorer communities in their own districts. Eric Rosengren, president of the Boston Fed, took former chair Janet Yellen to Chelsea, an industrial, majority Hispanic town across the Mystic river from Boston. Robert Kaplan of the Dallas Fed took Mr Powell to Dallas’s fifth ward.
Mr Rosengren, Mr Kaplan and Mr Kashkari say the Fed Listens events have been bolted on to existing processes and relationships they had in their own districts, both for community development and for data gathering.
What’s new, says Mr Rosengren, is that the Fed banks are not just heading out to learn about the economy, but also to ask about policy. “If you were somebody working at the carpenters’ union, we’d be asking, ‘How do you see the labour markets? How would you see what’s happening in construction in Boston?’” he says. “But we wouldn’t really talk about monetary policy and how it affects their membership.”
During the Fed’s December meeting, research staff laid out what they had learnt at the events. In keeping with what Ms Scott had told the chair in Washington, inflation “elicited fewer comments at these events and were generally seen as posing less of a challenge than labour market conditions”, according to minutes of the meeting released last week. Guests at the events, Fed staff explained, were worried about the rising cost of living and thought that low inflation was a good thing.
Fed staff also noted that guests at the Fed Listens events had said that the economic expansion had not yet reached their neighbourhoods in a way that national statistics might suggest. Policymakers, according to the minutes, heard at the events a confirmation that the longer the expansion continued, the more likely it would “reach more of those who, in the past, had experienced difficulty finding employment”.
The Fed Listens events represent a way to give policymakers, particularly from the board of governors, the same message, says Mr Kashkari. “For a couple of years I’ve been travelling around the district, meeting with community groups,” he says. “I’ve been hearing these messages about ‘there’s still slack’ literally for four years.”
As well as informing policy, the events may be serving another purpose: helping the Fed explain what it does, in plain English, to people who do not follow financial markets.
In September, Fed governor Michelle Bowman met the St Louis Fed’s advisory groups. She heard from Josh Poag, chief executive of Poag Shopping Centers in Memphis, Tennessee.
“I will admit in the four years I’ve been here I think this is the most robust conversation we’ve had,” he told Ms Bowman. Employers in the St Louis Fed’s real estate advisory group, he said, were searching for workers, and thinking about bringing on convicted felons and ignoring evidence of marijuana use, for example.
Mr Pogue added that any kind of transparency is good for the Fed, and that people who do not understand how monetary policy works may be more likely to trust what they learn on YouTube. “The smarter the Fed sounds, the less trust it will have. That’s a scary thought. But I think it’s accurate.”