BERKELEY – Economic developments over the past 20 years have taught – or ought to have taught – the US Federal Reserve four lessons. Yet the Fed’s current policy posture raises the question of whether it has internalized any of them.

The first lesson is that, at least as long as the current interest-rate configuration is sustained, the proper inflation target for the Fed should be 4% per year, rather than 2%. A higher target is essential in order to have enough room to make the cuts in short-term safe nominal interest rates of five percentage points or more that are usually called for to cushion the effects of a recession when it hits the economy.

The Fed protests that to change its inflation target even once would erode the credibility of its commitment to ensuring price stability. But the Fed can pay now or it can pay later. After all, what good is credibility today when it means sticking tenaciously to a policy that deprives you of the ability to do your job properly tomorrow?

The second lesson is that the two slope coefficients in the algebraic equation that is the Phillips curve – the link between expected inflation and current inflation, and the responsiveness of future inflation to current unemployment – are both much smaller than they were back in the 1970s or even in the 1980s. Then-Fed Chair Alan Greenspan recognized this in the 1990s. He rightly judged that pushing for faster growth and lower unemployment was not taking excessive risks, but rather harvesting low-hanging fruit. The current Fed appears to have a different view.

The third lesson is that yield-curve inversion in the bond market is not just a sign that the market thinks that monetary policy is too tight; it is a sign that monetary policy really is too tight. The people who bid up the prices of long-term US Treasury bills in anticipation of interest-rate cuts when the Fed overshoots and triggers a recession are the same people who are now on tenterhooks wondering when to start cutting back on investment plans because a recession will soon produce overcapacity.

The Fed today has a “habitat theory” about why this time is different – that is, why the preferences of investors for particular maturity lengths imply that a yield-curve inversion would not mean what it has always meant. But 2006, just before the financial crisis hit, was supposed to be different, too. (And there were plenty of times before then that were supposed to be different, too.) History suggests that this time is highly unlikely to be different – and that it will not end well if the Fed continues to believe and behave otherwise.

The fourth lesson similarly reflects developments extending back further than 20 years. Back in the 1980s, it was not unreasonable to argue that the next large shock to the US macroeconomy was likely to be inflationary. It is much more difficult to reasonably argue that today. For the past three and a half decades, the principal shocks have not been inflationary, like the 1973 and 1979 oil crises, but rather deflationary, like the US savings and loan crisis in the 1980s and 1990s, the 1997 Asian crisis, the 2000 dot-com bust, the terrorist attacks of September 11, 2001, the 2007 subprime collapse that began in the US, and the 2010 European debt crash.

Former Fed Chair Janet Yellen told me back in the 1990s that, in her view, conducting the Fed’s internal debate within the framework of interest-rate rules had greatly increased the ease of getting from agreement about the structure and state of the economy to a rough consensus on appropriate policy.

But, at least as I see it, right now the Fed’s process of getting from a realistic view of the economy to an appropriate monetary policy does not seem to be functioning well at all. Perhaps it is time for the Fed to place its internal discussions in a more explicit framework. One can imagine, for example, the Fed adopting an “optimal control” method, whereby monetary-policy settings are established by running multiple simulations of a macroeconomic model using different combinations of interest rates and balance-sheet tools to project future inflation and unemployment.

The problem for optimal control methods is that the real world is not some closed system where economic relationships never change, or where they change in fully predictable ways. The most effective – and thus the most credible – monetary policy is one that reflects not only the lessons of history, but also a willingness to reconsider long-held assumptions.

NEW HAVEN – November 2018 will mark the tenth anniversary of quantitative easing (QE) — undoubtedly the boldest policy experiment in the modern history of central banking. The only thing comparable to QE was the US Federal Reserve’s anti-inflation campaign of 1979-1980, orchestrated by the Fed’s then-chair, Paul Volcker. But that earlier effort entailed a major adjustment in interest rates via conventional monetary policy. By contrast, the Fed’s QE balance-sheet adjustments were unconventional and, therefore, untested from the start.

The American Enterprise Institute recently held a symposium to mark this important milestone, featuring QE’s architect, Ben Bernanke. What follows are some comments I offered in an accompanying panel session that focused on lessons learned from QE.

The most important lesson pertains to traction — the link between Fed policy and its congressionally mandated objectives of maximum employment and price stability. On this count, the verdict on QE is mixed: The first tranche (QE1) was very successful in arresting a wrenching financial crisis in 2009. But the subsequent rounds (QE2 and QE3) were far less effective. The Fed mistakenly believed that what worked during the crisis would work equally well afterwards. 

An unprecedentedly weak economic recovery – roughly 2% annual growth over the past nine-plus years, versus a 4% norm in earlier cycles – says otherwise. Whatever the reason for the anemic recovery – a Japanese-like post-crisis balance-sheet recession or a 1930s style liquidity trap – the QE payback was disappointing. From November 2008 to November 2014, successive QE programs added $3.6 trillion to the Fed’s balance sheet, nearly 25% more than the $2.9 trillion expansion of nominal GDP over the same period. A comparable assessment of disappointing interest-rate effects is reflected in recent "event studies” research that calls into question the link between QE and ten-year Treasury yields.

A second lesson speaks to addiction – namely, a real economy that became overly reliant on QE’s support of asset markets. The excess liquidity spawned by the Fed’s balance-sheet expansion not only spilled over into equity markets, but also provided support for the bond market. As such, monetary policy, rather than market-based fundamentals, increasingly shaped asset prices.

In an era of weak income growth, QE-induced wealth effects from frothy asset markets provided offsetting support for crisis-battered US consumers. Unfortunately, along with this life support came the pain of withdrawal – not only for asset-dependent consumers and businesses in the United States, but also for foreign economies dependent on capital inflows driven by QE-distorted interest-rate spreads. The taper tantrum of 2013 and the current travails of Argentina, Brazil, and other emerging economies underscore the contagion of cross-market spillovers arising from the ebb and flow of QE.

A third lesson concerns mounting income inequality. Wealth effects are for the wealthy, whether they are driven by market fundamentals or QE. According to the Congressional Budget Office, virtually all of the growth in pre-tax household income over the QE period (2009 to 2014) occurred in the upper decile of the US income distribution, where the Fed’s own Survey of Consumer Finances indicates that the bulk of equity holdings are concentrated. It is hardly a stretch to conclude that QE exacerbated America’s already severe income disparities.

Fourth, QE blurs the distinction between fiscal and monetary policy. Fed purchases of government securities have tempered market-based discipline of federal spending. This is hardly a big deal when debt-service costs are repressed by persistently low interest rates. But with federal debt held by the public nearly doubling between 2008 and 2017 – from 39% to 76% of GDP – and likely to rise further in the years ahead, what is inconsequential today could take on considerably greater importance in an interest-rate environment that lacks the QE subsidy to Treasury financing.

A fifth lesson pertains to the distinction between tactics and strategy. As lender of last resort, the Fed deserves great credit for stepping into the breach during a wrenching crisis. The problem, of course, is that the Fed also played a key role in condoning the pre-crisis froth that took the system to the brink. This raises a fundamental question: Do we want a reactive central bank that focuses on cleaning up the mess after a crisis erupts, or a pro-active central bank that leans against excesses before they spark crises?

That question – whether to “lean or clean” – has fueled a raging debate in policy and academic circles. It has an important political economy component: Are independent central banks willing to force society to sacrifice growth in order to preserve financial stability? It also bears on the bubble-spotting debate. Yet as difficult as these problems are, they pale in comparison to the foregone output of America’s anemic post-crisis recovery.

That raises two additional questions: Might a pro-active Fed have prevented the crisis from occurring in the first place? And should it be more aggressive in normalizing interest rates?

The Fed’s preference for glacial normalization both in the early 2000s and now keeps monetary policy on emergency settings long after the emergency has passed. Doing so raises the distinct possibility that the Fed will lack the ammunition it will need to counter the inevitable next recession. And that could well make the lessons noted above all the more problematic for the US economy.

Unsurprisingly, Bernanke offered a very different take on many of these issues at the AEI symposium. He argued that the Fed’s balance-sheet tools are merely extensions of its traditional approach, stressing that “conventional and unconventional monetary policy works through the same channels, with the same mechanism.”

That is debatable. By conflating QE-induced wealth effects with the effects on borrowing costs that arise through conventional channels, Bernanke conveniently sweeps aside most of the risks described above – especially those pertaining to asset bubbles and excess leverage.

Ten-year anniversaries are an opportunity for reflection and accountability. We can only hope that circumstances don’t require another unconventional policy experiment such as QE. But in the event of another crisis, it would pay to be especially mindful of QE’s shortcomings. Unlike Bernanke, I fear there is good reason to worry that the next experiment may not work out nearly as well.

ZURICH – The European Central Bank’s recent announcement that it will try to end asset purchases by this December means that it has confidence in its ability to achieve price stability. But those who decided that price stability should be the ECB’s single, overriding policy goal may have shot themselves in the foot, not least by denying policymakers much-needed flexibility.

The ECB defines price stability as inflation “below, but close to, 2% over the medium term.” That is a lower inflation rate than even the Bundesbank achieved during its celebrated pre-euro history, and it is a tighter target than virtually all other central banks pursue. For some, too much of a good thing is apparently wonderful.

To be sure, the ECB’s definition of price stability was not a problem during the period between the global financial crisis and the adoption of quantitative easing, when inflation was well below 2%. To those who believed that monetary policy had been too tight, the ECB was right to do whatever it could to push inflation up toward the target range.

Yet for those in favor of the ECB’s “stability-oriented monetary policy” – a term suggesting that others disregard the risk of monetary instability – the price-stability objective has evidently become too constraining. From their perspective, asset purchases never should have happened, and interest rates should have been raised long ago, despite the eurozone’s too-low rate of inflation.

It is safe to assume that those who hold this view were highly supportive of the ECB’s hardline price-stability objective. They would contend that low interest rates raise financial-stability risks that grow more acute with time. That is probably true. And yet it ignores the fact that raising interest rates prematurely can also fuel financial instability. In any case, the argument is moot, because the ECB’s mandate rules out any rate increase that could conflict with price stability.

Of course, those in favor of higher interest rates would counter that inflation of 1% or even less is in fact “close” to 2%, implying that price stability has been achieved and monetary policy can be tightened. In other words, they do not share the view that “close to 2%” means something in the range of 1.7-1.9%. But this is a pernicious argument. Running inflation below the level debtors had reason to expect translates into high real interest rates, which in turn risks triggering defaults among borrowers, including mortgagors, firms, and governments.

Undershooting the inflation target is also dangerous because inflation expectations and interest rates will decline over time, which makes it more likely that the ECB will reach the zero lower bound when the next downturn occurs. It also increases the likelihood that asset purchases will become necessary once again.

Those in favor of a policy tightening would also note that low rates are problematic for savers, insurance companies, and pension funds, whose portfolios often include few equities. But nowhere does the ECB’s mandate say that monetary policy should be set in the interest of savers or the financial industry.

As a practical matter, the ECB’s price-stability objective, originally designed to protect the eurozone from Italian-style inflation, has ended up protecting it from German-inspired deflation. But just because the ECB’s mandate has forced it to do the right thing on occasion does not mean that we will be so lucky in the future.

The global financial crisis required advanced economies’ central banks to contend with circumstances that those who crafted their mandates scarcely could have imagined. The fact that things often do not work out as expected is precisely why central banks’ objectives should be written to give policymakers flexibility – or poetic license to bend the rules – when extreme events occur. Otherwise, policymakers will be less effective than they otherwise could be.

Because the ECB’s price-stability mandate is legally codified by the Treaty on the Functioning of the European Union, it cannot be altered without a treaty amendment. But the phrase “below, but close to, 2%” is the ECB’s own, and thus can be changed with the stroke of a pen.

As such, the ECB should consider two alterations. First, it should get rid of the ambiguity inherent in the words “close to,” by setting a point target to provide clarity to the public – and to ECB Governing Council members – about what its monetary policy aims to achieve. Whether that target is 1.8% or 2%, or whether it is surrounded by a range, is less important.

Second, the ECB must clarify how financial stability and business conditions factor into its policy decisions. Many have argued that lengthening the policy horizon by precisely defining “the medium term” would give policymakers room to pursue other objectives temporarily. After all, because financial crises and deep recessions are deflationary, they, too, jeopardize price stability.

With the ECB finally exiting the last crisis, now is a good time to reflect on what lessons it has (or should have) learned. The ECB must not delay in positioning itself for the next downturn.

OXFORD – The Bank of England raised interest rates to 0.75% this month, in the belief that inflation will exceed its mandated 2% target in about two years. But raising interest rates tends to dampen economic activity, and growth is hardly rampaging in the United Kingdom. Should the BoE consider a change to its mandate to include economic growth?

In the United States, the Federal Reserve has a dual mandate: price stability and maximum employment. Of course, the Fed has also raised interest rates this year; but the US economy is growing at over 4% and GDP is expected to be around 3% higher this year.

By contrast, the UK economy grew just 0.2% in the first quarter of this year. While the BoE expects growth to rebound and end up at around 1.5% for the year, it describes this rate as the “speed limit.” Faster growth would fuel inflationary pressures.

With UK unemployment at 4.2% – a level consistent with full employment in the BoE’s view – hiring workers will mean higher wages. And, because price increases are a function of wages plus a mark-up, inflation will rise. The BoE’s decision to raise interest rates despite slow economic growth reflected its concern for its 2% inflation target.

Given that the British economy grew at an average of 2.5% between 1980 and 2007, the BoE’s projection of 1.5% potential growth amounts to a significant downgrade. The culprit is poor productivity growth. From 1998 until the 2008 global financial crisis, annual productivity growth averaged 2.25%. The BoE now believes the rate to be closer to 1-1.25%.

This productivity slowdown has occurred across advanced economies, for reasons – adverse demographic trends, lower investment demand, or any of a slew of other possible explanations – that remain unclear. But Britain is the worst affected. And slower economic growth leads to an expectation of lower interest rates.

For the first time, the BoE has produced an estimate of what the “new normal” interest rate is likely to be, in line with its growth forecasts. Rather than the 5% average rate that prevailed in the decades before the banking crisis, the BoE now expects interest rates to be 2-3%, implying a real (inflation-adjusted) interest rate of below 1%. That is not out of line with estimates of where interest rates might be for other advanced economies experiencing a productivity slowdown.

But, because the BoE believes the economy is already growing at its full potential, it has raised interest rates now, even though GDP growth is slow and is estimated to only reach 1.7-1.8% between now and 2021, the end of its forecast period. This is why the BoE’s latest move looks curious. Won’t the effects of higher rates on borrowing, spending, and investment by households and firms lead to even slower growth?

Of course, monetary policy affects the business cycle, not the economy’s long-term prospects, which depend on, among other things, technological innovation and the skills of the workforce. So the BoE’s actions will not change the British economy’s potential growth rate. But would a growth mandate give the BoE greater pause before raising rates when growth is anemic?

Consider a scenario in which the BoE were given a mandate to maximize economic growth and meet a 2% inflation target. If policymakers expected inflation to reach 2%, but economic growth to be less than 2%, in two years, then they would need to balance how much economic dampening a rate rise would bring about. In other words, their inflation target may be met, but if growth is tepid, confronting a trade-off between the two targets might stay the BoE’s hand for a while longer – just as the Fed keeps an eye on employment, even though monetary policy doesn’t really affect long-run growth.

What makes this tricky is that it is hard to estimate an economy’s potential growth rate, which can change. If productivity growth picked up, then 2.5% GDP growth could again be the “speed limit.” So, a central bank with a growth mandate may tread a bit more carefully in case its actions dampened activity that could increase national output to its new potential rate.

Another reason for the BoE to consider a mandate that includes economic growth is the weakening relationship between inflation and the rest of the economy. In other words, unlike in the past, price growth is not that closely related to unemployment or output.

For example, inflation was high in the immediate aftermath of the 2008 crisis, suggesting that the UK economy was booming when it wasn’t; unemployment was fairly high then as well. Prices were rising because the pound was weak, boosting the cost of imports, and global oil prices were high.

During this period, the BoE often missed its inflation target, fueling criticism that the target was ineffectual. The reason not to raise rates, however, was evident: the economy was coping with the aftermath of the Great Recession. With economic growth as an explicit part of its mandate, the BoE could explain itself better in such circumstances – and better maintain the credibility of its commitment to price stability.

Targeting price stability alone may have worked when inflation was a more reliable proxy of the business cycle. Now that it isn’t, the BoE – and perhaps other central banks – should consider a change in mandate to target growth as well.

LONDON – The changing of the guard that is taking place at the systemically important central banks in 2018-2019 will mark the beginning of a new era of monetary policy. Who is likely to lead this transition to a “new normal”? More important, just how new will it really be?

In the decade since the global financial crisis, advanced-country central banks have adopted unprecedentedly active monetary policies. The Bank of Japan’s Haruhiko Kuroda and the European Central Bank’s Mario Draghi maintain such policies to this day, in order to stimulate economic activity and counter deflationary pressures. By contrast, the US Federal Reserve, beginning under former Chair Janet Yellen, and the Bank of England, under Mark Carney, have been laying the groundwork for policy “normalization.”

Another systemically important central bank, the People’s Bank of China, has focused not on monetary expansion, but on financial reform. Former PBOC Governor Zhou Xiaochuan built a strong reputation domestically and, perhaps more so, internationally during his record-setting 15-year tenure, owing to his gradual, steady, and effective approach. Although the PBOC’s lack of official independence means that his authority to set interest rates was constrained by the advice of the 15-member Monetary Policy Committee, this did not affect Zhou’s ability to put in place the foundations of a financial sector befitting the world’s largest economy.

Yet, even as central banks face important transitions, the choices of their new leaders have reflected a desire for continuity. Most obvious, Kuroda has been confirmed for another five-year term at the BOJ, and Zhou was replaced in March by his own deputy governor, Yi Gang. Even Yellen’s successor, Jerome Powell, will probably amount to more of the same.

Of course, Powell was initially presented as a break from the past. After all, if President Donald Trump had wanted to remain on the same path, he would have just selected Yellen for a second term (which would have been more in line with tradition). But, in Trump’s view, the Democrat Yellen was a vestige of Barack Obama’s administration, and thus had to be replaced with a declared Republican like Powell. But both Powell and Yellen are Fed veterans, and seem to be following the same normalization path.

In Europe, the changes brought by the new governors are likely to be more significant. At the BoE, Carney – who announced in November 2016 his intention to cut short his term – will remain in the job until a few months after the United Kingdom’s exit from the European Union in March 2019, in order to minimize any market disruption.

But Carney’s replacement is likely to represent a significant departure. Despite his impeccable track record as the governor of Canada’s central bank, Carney’s appointment was controversial: he has always been perceived as too close to the previous chancellor of the exchequer, George Osborne, and insufficiently sympathetic to Brexiteers. Carney’s successor will thus have to be congenial, if not amenable, to Brexit’s champions.

In a sense, however, Carney’s replacement will amount to the restoration of the status quo. After all, when Carney was “imported,” he was disrupting the tradition of in-house appointments – a tradition that will be revitalized if, as seems likely, one of the BoE’s current deputy governors is named as his replacement.

Perhaps the most profound shift will happen at the ECB, where four top posts will need to be filled by the end of next year. The recent nomination of former Spanish economy minister Luis de Guindos to serve as ECB vice president offers some clues regarding what to expect.

In particular, the choice of a Spanish vice president (which in Guindos’s case represents a break with the tradition – intended to protect central-bank independence – of not appointing politicians) suggests that the next president will come from the northern eurozone. Of the eurozone’s three largest economies, only Germany has never held the presidency. If the presidency goes to a German, that German will most likely be Bundesbank President Jens Weidmann.

A monetary hawk, Weidmann will struggle to win southern countries’ support. Moreover, his nomination will trigger the resignation of another German, Sabine Lautenschläger, the only woman on the ECB’s executive board. The prospect of an exclusively male board – not to mention the fact that no woman was even short-listed for the presidency – will not go down well with the European Parliament.

The European Parliament’s preference for greater gender parity is surely welcome, though it is probably based more on a desire to avoid criticism than a genuine commitment to diversity. And, in fact, with their selections for the top jobs, all central banks are failing in this respect, even though diversity is now viewed, in many institutional contexts, as an indicator of good performance. In short, central-bank leadership remains an “old boys’ club.”

As we enter a new era for monetary policy, we should be seeking to overhaul central-bank leadership in a more fundamental way. The lack of diversity among candidates for the top jobs suggests that the selection process is far too narrow and inward-looking. Central banks ought to be cultivating younger people, women, and minorities, in order to broaden the range of approaches, skills, perspectives, and expertise that effective monetary policymaking will require in the future.

Real change eventually will come. But for now, in terms of both policy and personnel, it’s mostly old wine in familiar bottles.