To many Fed officials, inflation has become a puzzle — largely because it seems to have disappeared. Earlier this year, Powell admitted that low inflation numbers were “kind of a mystery.” Since adopting a symmetric 2% inflation target in 2012, the Federal Reserve has routinely undershot it, seeing a decline to 1.3% in recent months. Senators need to ask for answers beyond the specific price changes — things like e‐commerce, falling wireless prices, or prescription drug prices — that Chair Yellen has cited as headwinds for inflation.
Those are microeconomic issues. Senators should seek Powell’s views on what macro factors might be holding inflation down.
At the annual Jackson Hole gathering of Fed officials last June, Powell said that below‐target inflation gave the Fed time to raise rates. The Committee should press Powell on whether persistent undershooting of the inflation target would prompt him to delay the three rate increases projected for next year. Senators should also ask if the Fed’s inability to hit its inflation target suggests there needs to be a change in the dual mandate.
Second, the Committee should press for clarity on Powell’s view of the Fed’s operating framework, and ask in particular whether he thinks post‐crisis changes to the way the Fed conducts monetary policy are contributing to the inflation “mystery.”
Before the 2008 crisis, reserves — cash held by banks at the Federal Reserve — were scarce. Banks kept reserve balances at the Fed to satisfy regulatory requirements, and would lend excessreserves to each other as part of the settling and clearing of payments on any given day. The interest rate on these loans is the federal funds rate. The Fed would implement its policy decisions by changing the quantity of reserves available to the banking system, thereby raising the federal funds rate if it wanted tighter monetary policy, or lowering it if it wanted policy to be looser.
But since quantitative easing flooded the financial system with reserves, monetary policy can no longer be conducted that way. The Fed now uses two administered rates — interest on excess reserves and the overnight reverse repo rate — to maintain control over short term interest rates, with IOER being the “key tool” for conducting monetary policy. The Fed directly sets a range for the policy rate, rather than influencing it by actively participating in the federal funds market.
In a speech in June, Powell indicated his support for continuing to use the two administered rates to set monetary policy. As long as the Fed’s balance sheet remains at its current size, this is to be expected; as things stand, altering the amount of reserves in the financial system would have no effect on the policy rate.
But what about once the balance sheet has been cut down to size?
Powell has said that the precrisis framework was resource‐intensive for the Fed and its counterparties, and that the current floor system would be more robust over time.
Does he believe the current system would prove better in combating a recession or in handling a crisis, or does it have some other advantages?
Has he considered the possibility that the Fed’s post‐crisis operating framework, which revolves around an above‐market interest rate paid on excess reserves, is part of the Fed’s failure to reach its inflation target?
Third, the Committee should seek further details on Powell’s views on monetary policy rules.
Powell concluded a speech in February by saying that simple policy rules are “useful” in identifying the appropriate path for monetary policy, particularly in a crisis. Just as importantly, rules provide benchmarks against which a central bank’s previous performance can be judged. Earlier in that speech, Powell referred approvingly to the Cleveland Fed’s dashboard of seven monetary policy rules.
Senators should ask Powell which of these rules he favors over others. They should further inquire as to how the Fed might use rules under Powell’s leadership. Rules are an important check on the potential biases of FOMC members and would help ensure the proper conduct of monetary policy.
The inflation puzzle, the operating framework, and monetary rules represent some of the most pressing issues in central banking today. To gauge whether Jerome Powell is ready to be a careful steward of monetary policy, the Fed should focus its questions on precisely those issues.