Priorities for the Next Federal Reserve Chair: Completing the Revolution in Macroeconomic Policy

Starting in 2018, Federal Reserve Chair Jerome Powell began to question the conventional ideas about how the Federal Reserve (the Fed) was carrying out its dual mandate for maximum employment and stable prices; since then, he’s led an overhaul of the institution, guiding it to make full employment and strong recoveries much more central to its mission. This led to two years of unemployment below 4 percent—levels many economists believed we could not sustain—and has put us on a path to a recovery from the COVID-19 pandemic that will put incomes above pre-crisis predictions. One of the crucial battles this year for those who want to see a more equitable and just economy is ensuring that the changes Powell put into motion over the past several years become embedded in the everyday policy and practices of the Federal Reserve.

The fight over the next Federal Reserve chair is therefore not just about nominating a candidate who is dovish on monetary policy and open to unemployment being lower than before the pandemic, though that is essential. It is also about securing the changes that have already occurred for the next generation. Only someone deeply committed to institutionalizing this overhaul of policy and who has the ability to execute it should be considered for the role.

A Revolution in Economic Thinking
There are four core shifts in thinking that we need to secure beyond this immediate recovery:

We can have much tighter labor markets than what has counted as full employment in recent decades. Moreover, the number of people who could be in the labor force isn’t fixed by incentives and technology, but is determined by macroeconomic policy itself;
The risks of a weak recovery are greater than of overheating, and long periods of unemployment have lasting negative effects on economic growth. Beyond that, periods of low unemployment have significant positive distributional impacts and can help those most disadvantaged in normal labor markets;
Full employment requires an across-the-board approach, including support for fiscal stimulus, but also additional unconventional monetary tools such as those deployed in the pandemic; and
Allowing for periods of higher-than-expected inflation is essential to robust recoveries. This shift, embodied in a new inflation targeting framework, will prevent the confusing, start-and-stop guidance that contributed to the slow recovery after the Great Recession. It also allows the Fed to take a wait-and-see attitude to current inflation and not let it dominate monetary policy.
These are all radical ideas that the Fed has started incorporating into official policy, and this process must continue. For years, the Roosevelt Institute has documented these changes and the Fed’s adoption of new economic ideas.

Powell has taken a strong lead in arguing—against conventional wisdom—that labor markets were not tight in 2019, even as the Congressional Budget Office argued that we were already above potential output. In testimony from July 2019, Powell argued that “​​We don’t have any basis for calling this a hot labor market” and that he thought “we have learned that the economy can sustain much lower unemployment than we thought without troubling levels of inflation.” 

Powell also called into question the idea that you could estimate the level of full employment in advance of reaching it, arguing that “3.7 percent is a low unemployment rate but to call something hot you need to see some heat. We hear lots of reports of companies having a hard time finding qualified labor, but we don’t see wages responding.” ​​When asked if the Fed had gotten the natural rate of unemployment wrong over the previous decade, Powell responded: “Absolutely. I think we have learned that this is something you can’t identify directly.”

The same is true of the positive distributional consequences of full employment. While economists in recent decades have argued that the state of the labor market has little impact on the distribution of incomes and the size of the labor force, Powell has taken the Fed in a different direction. In November 2019, he said the Fed had “heard that many people who in the past struggled to stay in the workforce are now working and adding new and better chapters to their lives. These stories show clearly in the job market data. Employment gains have been broad based across all racial and ethnic groups and all levels of educational attainment as well as among people with disabilities.” By early 2020, the Fed’s expansionary policy led to the lowest Black-white unemployment gap in 50 years, and there was every sign it would have continued to close had the COVID-19 pandemic not occurred.

This same shift in perspective is clear in a February 2021 speech in which Powell described new guidance policies: “A strong labor market that is sustained for an extended period can deliver substantial economic and social benefits, including higher employment and income levels, improved and expanded job opportunities, narrower economic disparities, and healing of the entrenched damage inflicted by past recessions on individuals’ economic and personal well-being.” The phrasing of “entrenched damage” is noteworthy here, as it describes the persistent negative consequences currently hanging over the economy of failing to hit full employment, something macroeconomic theory often fails to recognize.

Powell has also overseen the adoption of a new approach to inflation. As he said in 2021, “Recognizing the economy’s ability to sustain a robust job market without causing an unwanted increase in inflation,” the Fed is willing to risk higher-than-expected inflation over a short period of time to ensure full employment and “will not tighten monetary policy solely in response to a strong labor market.” It is essential this new inflation target regime succeed and become embedded inside the Federal Reserve; as Powell noted in 2019, “Around the world, however, we have seen that inflation running persistently below target can lead to an unhealthy dynamic in which inflation expectations drift down, pulling actual inflation further down . . . That is why it is essential that we at the Fed use our tools to make sure that we do not permit an unhealthy downward drift in inflation expectations and inflation.” Being able to not only propose a new inflation targeting regime but secure the coalition of partners necessary to execute it and stand by it during this recovery year has changed the way we fight recessions.

A Successful Response to the Pandemic
The shift in the Fed’s thinking under Powell was also visible in its response to the pandemic, as seen in the successful emergency lending programs instituted during the immediate panic in March and April of 2020. Normally, the Federal Reserve lowers overall short-term interest rates, hoping banks will pass these on to their borrowers. During the COVID-19 crisis, however, the Fed created programs to directly lower the long-term rates faced by the non-financial economy. Especially as lending markets locked up and rates soared, corporations and states found themselves at the mercy of the most predatory financial firms who could opportunistically use their wealth in the panic to demand exploitative rates. But thanks to the Fed’s interventions, the financial crunch quickly passed. This was an important departure from previous crises, signaling that it was no longer up to vulture funds and private equity to determine which companies survived the immediate panic, and on what terms.

Some have criticized the Municipal Liquidity Facility (MLF), designed to provide support to public governments during the 2020 crisis, for only having two entities use it. But a deeper analysis focuses not just on direct lending but the broader effects of the program’s existence on interest rates themselves. As the Federal Reserve Bank of New York found, “between March 2 and March 23, the yield on AAA [municipal bonds] jumped 1.8 percentage points” yet by June, for “AAA and AA securities, yields have returned to their pre-pandemic levels and are now near all-time lows.” Researchers at the Federal Reserve Bank of Kansas City found that the spike in municipal bond rates was likely “due to liquidity concerns, not state-specific credit risks,” and that the spread between municipal and Treasury yields spiked and then collapsed right in line with the Fed’s interventions. According to the Federal Reserve Bank of Chicago’s look at the Illinois bond market, “the April 9, June 3, and August 11 announcements [about the MLF] had a statistically significant negative impact on Illinois muni yields, reducing the three- and four-year muni–Treasury spreads by about 220 [basis points].” Looking beyond the outlier of Illinois and across a panel of 20 states, the Chicago Fed researchers also found that “the total average impact of the Fed announcements is about 110 [basis points].” This is strong evidence that even though the MLF did very little direct lending, its mere existence calmed the panic in markets and thereby preserved the ability of state and local governments to borrow on reasonable terms.

There is still ongoing research on these topics, but an estimated 110 basis point fall in state credit spreads is nearly one and a half times the reduction of credit spreads that the private corporate bond market is estimated to have gotten from the Federal Reserve’s Secondary Market Corporate Credit Facility (SMCCF). In response to breakdowns in corporate lending in March 2020 (Liang 2020), the Federal Reserve was willing to purchase corporate bonds on the secondary market. (The facility for new direct corporate bond purchases, the Primary Market Corporate Credit Facility [PMCCF], ended up making no loans, compared to the two issuers who used the MLF. The SMCCF ended up purchasing a small amount of around $14 billion in debt, with the real impact being on rates themselves.) Most estimates of the SMCCF found that eligible firms saw a comparable credit spread reduction of around 70 basis points (Gilchrist et al 2020; Li and Momin 2020). In the absence of Fed intervention, productive businesses might have been subject to mass bankruptcies and to financial looting by whatever private financial institutions had money to lend. These failures could have made our recovery even worse; instead of just problems with the used car market, it could have been our entire productive capacity struggling to work through a collapse due to lack of reasonable credit.

The guiding principles for economic policy may change profoundly in the wake of the Great Recession and the COVID-19 pandemic, but there’s no guarantee. A turn back to the old inflation-phobic, pro-austerity mindset at the Fed will only serve conservative ends, and will make long-term change even more difficult. If we fail to convince the Federal Reserve to continue and normalize its new approach, or worse, if the next Fed chair pauses or hesitates on this recovery, that could destroy this entire new liberal project for a generation—not just here, but across nations. All the battles we’ve fought for a bigger public sector, for full employment, and for an economy that provides jobs with dignity will have been in vain, if the Fed restrains the recovery in a monetary straitjacket. But if the Fed’s new approach to employment and inflation are embedded and institutionalized, it will offer a new formula for combating recessions and fostering economic booms.