The Fed’s Strategy on a Targets-based Monetary Policy Framework

Research by: Florian Gerth, and Yiyang Bian

Executive Summary

The purpose of this study is to summaries and theoretically analyze the toolset available for central banks all around the world to fight the zero-lower bound of interest rates. This is important since an effective nominal interest rate of zero demands monetary policy to re-focus its approach to lifting inflation to its desired level, ultimately maintaining price stability within the economy.

Major economic and financial contractions usually go hand-in-hand with muted inflation. This has been true for the Great Depression, the Global Financial Crisis, as well as the Covid-19 crisis. In this paper, we theoretically highlight and discuss the evolution of instruments and approaches monetary-policy decision makers at the Federal Reserve have in lifting inflation to desired levels in times of the zero-lower bound, paying particular focus on more rigorous developments like asymmetric average inflation and temporary price-level targeting. It is therefore a tractable complement to more quantitative papers structurally analyzing monetary policy tools during a low-inflationary period.

The main contributions of the paper are as follows:

1. Discussion of the evolution of central bank tools and targets during different regimes of inflation variability.
2. Analysis of the developments of conventional monetary policy tools, instruments, and objectives.
3. A look at alternative instruments and approaches during the zero-lower bound of interest rates, as part of the Federal Reserve’s unconventional monetary policy.

Aside from having control over the short-term policy rate, central banks all around the world have adopted two unconventional tools that either change the expectations about future short-term rates or directly the yields of long-term rates in financial markets. The first of these tools is called Forward Guidance (FG). It maintains the idea of changing the expectations economic agents have about the future behavior of short-term interest rates. The second instrument in the toolset of a central bank is Quantitative Easing (QE), also known as Large-Scale Asset Purchases (LSAP). Instead of changing expectations about the behavior of interest rates in the future, this instrument allows to directly manipulate the yield of public and private long-term financial assets. By extending the traditional tool set by these instruments, central banks have the possibility to pursue any of the following approaches:

1. Price-level targeting,
2. Average inflation targeting,
3. Asymmetric average inflation targeting, and
4. Temporary price-level targeting.

The paper discusses in detail these four main approaches that give the monetary policy authority the possibility to directly influence the behavior of inflation or prices in the short and medium term.

To cite this article:  Gerth, F., & Bian, Y. (2023). The Fed’s strategy on a targets-based monetary policy framework. Financial Economic Letters, 2(1), 22 29. https://doi.org/10.58567/fel02010003

To access this article: https://doi.org/10.58567/fel02010003

About the Journal

Financial Economics Letters (FEL) is a scholarly peer-reviewed journal invited submissions in all areas of financial economics, broadly defined. FEL’s emphasis is on theoretical developments and their implementation, empirical, applied, and policy-oriented research in financial economics.

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