Is the Federal Reserve’s Faith in the NAIRU Still Strong? – J. W. Mason

Is the Federal Reserve’s Faith in the NAIRU Still Strong? – J. W. Mason

# The Evolution of Monetary Policy Thinking at the Federal Reserve

(I write occasional opinion pieces for Barron’s. This one was published there in October 2024. My previous pieces are here.)

Not long ago, there was widespread agreement on how to think about monetary policy. When the Federal Reserve hikes interest rates, this story went, it makes credit more expensive, reducing spending on new housing and other forms of capital expenditure. Less spending means less demand for labor, which leads to higher unemployment. With higher unemployment, workers accept smaller wage gains, and slower wage growth translates to slower growth in prices — lower inflation.

This traditional story had implications like a unique level of unemployment consistent with a stable 2% inflation rate, known as the NAIRU. The story also assumed that wage- and price-setting depend on expectations of future prices. Central banks were required to stabilize not only current inflation but also beliefs about future inflation to maintain price stability and full employment.

In the aftermath of the 2007-2009 financial crisis, the conversation surrounding monetary policy and inflation shifted. Federal Reserve Chair Jerome Powell, who assumed office in 2018, exhibited a more open-minded approach compared to his predecessors. The crisis and the slow recovery that followed prompted a reevaluation of traditional economic models and theories.

The Fed’s strategic review process in 2019 marked a significant turning point in its approach to monetary policy. The commitment to allow future overshooting of the 2% inflation target to make up for past shortfalls demonstrated a departure from the previous dogmatic adherence to the NAIRU framework. The recognition of long-term effects of demand shortfalls and a more data-dependent approach signified a shift in Fed’s thinking.

Recent empirical work by Arbogast, Van Doorslaer, and Vermeiern analyzed speeches by FOMC members from 2012 to 2022, quantifying the shift in language used regarding the NAIRU. The paper highlighted a notable move away from the NAIRU framework by FOMC members, especially under Powell’s leadership. The changing composition of the FOMC played a significant role in this shift.

## FAQ

### Has the Federal Reserve’s approach to monetary policy and inflation changed in the past decade?

Yes, there has been a discernible shift in the Fed’s thinking regarding the traditional NAIRU framework towards a more data-driven, holistic approach under the leadership of Jerome Powell.

### What are the implications of a move away from the NAIRU framework?

Moving away from the NAIRU framework allows the Fed to consider the long-term effects of demand shortfalls and explore alternative perspectives on the relationship between labor markets and inflation.

### How has the composition of the FOMC influenced this shift in policy approach?

The changing composition of the FOMC, with members more open to alternative perspectives than the fixed NAIRU framework, has played a vital role in shaping the Fed’s evolving approach to monetary policy.

## Conclusion

The evolution of the Federal Reserve’s thinking on monetary policy and inflation signals a departure from traditional models towards a more nuanced, data-driven approach. The shift away from the NAIRU framework underlines the importance of considering long-term effects and alternative perspectives in central bank decision-making. As the Fed continues to navigate economic challenges, it will be essential to examine not just its actions but the underlying rationale for those actions in shaping future policy directions.

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