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21November2017USEconomicPerspectivesNorthAmericaUnitedStatesEconomicsUSEconomicPerspectivesDate21November2017DeutscheBankResearchFedpolicyframework:Istheprice(level)right?■Inrecentweeks,manyFedofficialshaveraisedthepossibilityofre-consideringtheFed'scurrentpolicyframeworkoftargetinga2%inflationrate.ThispossibilityhasbeenmentionedbyregionalFedpresidentsacrossthehawk-dovespectrum,includingMester,Williams,Bostic,andEvans.Tomorrow’sminutescouldprovidefurtherindicationsthatthisisbecomingalivelydebateamongFedofficials.Giventhebreadthandincreaseintheintensityofthisdiscussion,marketsshouldtakenote.■Thereareseveralreasonswhythisdebateisheatingup.First,thereisagrowingconsensusamongFedofficialsthatr-starislikelytoremainlow,increasingtheoddsofhittingthezerolowerboundandreducingthecurrentframework'seffectiveness.Second,theturnoverinFedleadershippresentsanopeningforaseriousre-thinkofitspolicyframework.Third,therelativelycalmeconomicbackdropisconducivetothisdebate,andaframeworkchange,ifitoccurs,wouldbeinplacewellbeforethenextdownturn.Fourth,theFedmaybeconstrainedinitsfutureuseofextraordinarymonetarypolicy,soaframeworkthatmakesitlesslikelytobeinthatsituationwouldimprovemonetarypolicy'soveralleffectiveness.■Wedetailvariousoptionsfornewframeworks,focusingontheprosandconsofeach,alongwithmarketimplications.Theseoptionsincludeahigherinflationtarget,priceleveltargeting,nominalGDPtargeting,temporaryversionsoftheprecedingframeworks,andenhancedforwardguidancewhenthefedfundsrateisatthezerolowerbound.■Alloftheoptionshavedrawbacksandnoneclearlydominatethecurrentframework.Weviewahigherinflationratetargetasleastlikely,andseeabitmoremeritinaprice-levelornominalGDPtargetingframework.Ofnotearethetemporaryversions,whichonlyapplyattheeffectivelowerbound,mitigatingthecoststhatsocietybearsinnormaltimes.■Giventhesignificantdrawbackstoeachoption,weareunconvincedthatameaningfulmarket-relevantchangewilloccur.Morelikely,inertiacouldkeepthecurrentframeworkinplacewithclosecallsbetweenthealternatives'prosandcons.UnconventionalmonetarypoliciesthatmitigatethepainofzerolowerboundeventsalsoreducethelikelihoodoftheFedoverhaulingitsentireframework.WeexpectthatitwilltakesometimeforanyconclusiontobereachedabouthowtochangetheFed’sframework,ifatall.Nonetheless,marketparticipantswillhearagooddealmoreabouttheseoptionsoverthecomingmonths.MatthewLuzzetti,PhDSeniorEconomist+1-212-250-6161JustinWeidnerEconomist+1-212-469-1679PeterHooper,PhDChiefEconomist+1-212-250-7352BrettRyanSeniorUSEconomist+1-212-250-6294TorstenSlok,PhDChiefEconomist+1-212-250-2155DeutscheBankSecuritiesInc.DISCLOSURESANDANALYSTCERTIFICATIONSARELOCATEDINAPPENDIX1.MCI(P)083/04/2017.Distributedon:21/11/201720:09:07GMT0bed7b6cf11c21November2017USEconomicPerspectivesIntroductionInrecentweekstherehasbeenabarrageofFedofficialsraisingthepossibilitythattheFedcouldre-consideritscurrentpolicyframeworkoftargetinga2%inflationrate.Thispossibilityhasbeenraisedbyofficialsacrossthehawk-dovespectrum,includingregionalFedpresidentsMester(Cleveland),Williams(SanFrancisco),Bostic(Atlanta),andEvans(Chicago).Recently,formerFedchairBernankehasalsowrittenextensivelyaboutoptionsforanewpolicyframework.1Tomorrow’sminutesmayalsoprovidefurtherindicationsthatthisisbecomingalivelydebateamongFedofficials.GovernorPowell,whohasbeennominatedforFedchair,isknownforbeingaconsensusbuilderandwouldlikelywelcomeandencouragethisdiscussion.EvenifnochangesendupbeingmadetotheFed'soperatingframework,thediscussionsareinformativeabouttherelativepositionsofkeyFedofficials,somarketsshouldtakenote.Inthisreportwefirstdetailwhythisdebateispickingupsteamnow.Next,wediscussthevariousoptionsforanewpolicyframework,withparticularfocusontheprosandconsofeachpossibility,aswellastheimplicationsformarkets.Weconcludebypresentingourspeculationforhowthedebatewillproceedandpotentiallyconclude.Whyconsideradifferentframework?TheFedcurrentlyhasadualmandateofachievingmaximumsustainable(or“full”)employmentandpricestability.The“fullemployment”prongofthismandatedoesnotimplythattheFedshouldpushtheunemploymentrateaslowaspossible.Instead,theFedaimstominimizecyclicalunemploymentandachievealevelofemploymentthatdoesnotundulyraiseinflationrisks.The“pricestability”partofthedualmandateisdefinedas2%inflationaccordingtothePCEpriceindex.TheFedviewsthistargetassymmetric,implyingthatitsresponsetoanundershootofitsinflationtargetshouldbeequaltothemagnitudeofitsresponsetoanovershoot,conditionalontheunemploymentsituation.Thisframeworkiswell-understoodandhasseemedtoworkrathereffectively,atleastonthesurface,sowhyisthereadebate?Thefirst,andmostimportantfactor,inourview,isagrowingconsensusamongFedofficialsthattheneutralrealfedfundsrate,orr-star,islikelytoremainlowinthecomingyears.Thisviewhasbeensupportedbyabodyofempiricalresearchthathasestimatedadecliningr-starovertime,particularlysincethecrisis(Figure1).2Consequently,thepeakfedfundsrateduringtighteningcyclesgoingforwardwilllikelybelowerthanithasbeenhistorically,whichraisestheoddsthatmonetarypolicywillbeconstrainedbytheeffective,orzero,lowerboundoninterestratesmovingforward.3T