The Supply Problem In The Fed's Framework - Part 5: Revising The Consensus Statement For Supply-Aware Monetary Policy
This is the final post in our multi-part series on the Fed's 2025 framework review and strategy for dealing with supply shocks. Part 1 discusses how the Fed can deal with tariff inflation risks, Part 2 discusses the implications of recent productivity dynamics, Part 3 discusses the Fed's inflation and supply shock communication failures of the past few years, and Part 4 discusses the implications of sectors with interest rate sensitive investment dynamics, like housing and energy, for future supply shocks and Fed policy. The Fed has an opportunity to learn valuable lessons from the past few years and apply those lessons in a forward-looking manner. By revising its framework accordingly, Fed policy and communications can exhibit more robustness in the face of supply shocks and risks.
The Federal Reserve is currently undergoing its 2025 Framework Review — a formal evaluation of how it defines, pursues, and communicates its statutory objectives to pursue maximum employment and stable prices. This review is a critical opportunity for the Fed to evolve its thinking in an era now defined by volatile supply chains, energy transitions, geopolitical shocks, and changing investment needs. Just as the 2020 Framework Review reflected a translation of prior learnings into future Fed actions, the current Framework Review could prove pivotal in how the Fed responds to the shocks of the next five years.
The Fed’s framework, as specified in its “Statement on Longer-Run Goals and Monetary Policy Strategy”, and also known as the “Consensus Statement,” reflects an explicit appreciation for the role of financial shocks and a stable financial system in how the Fed fulfills Congress' directives over the longer run. Unfortunately, the Fed’s Consensus Statement does not reflect similar thinking about the role of shocks to the supply side of the economy.
The past few years have demonstrated how demand- and supply-side forces profoundly shaped macroeconomic outcomes, and how productive capacity affects both sides of the dual mandate. The Fed’s framework should correspondingly reflect how supply-side disturbances, whether in traded goods, electricity, or housing, can affect their policies and strategies for achieving the "dual mandate" objectives of maximum employment and stable prices. By orienting their inflation targeting communications around the growth rates of nominal consumer spending and gross labor income, the Fed could better navigate the trickier constellations of data that supply-side disturbances sometimes impose. This piece lays out specific revisions to the Fed’s statement that would reflect an intent to pursue a more “Supply-Aware Monetary Policy.”
The Framework Fails to Recognize the Importance of Supply Shocks
The Fed’s current framework is oriented around “Flexible Average Inflation Targeting.” Said more plainly, it’s a 2% inflation target that discretionarily tolerates overshoot when either high unemployment is a risk or inflation has run persistently lower than its target. Discretion is a double-edged sword, but when used well, it can account for the uncertainties and complexities of a dynamic, decentralized market-oriented economy. Used poorly and it enables major blindspots to macroeconomic forces that distort inflation from their longer run trajectory, while delivering more persistent and sizable losses in employment and output. Distorted one-time inflationary effects should be of heightened interest if we are indeed at risk of sectoral shocks, cost-push dynamics, and geopolitical disruptions.
"We may be entering a period of more frequent, and potentially more persistent, supply shocks—a difficult challenge for the economy and for central banks." - Chair Powell in prepared remarks on May 15, 2025
The Fed’s current framework has little capacity to account for short run inflation risks stemming from declining housing investment, volatile trade policy, or even simple swings in energy prices, which now may be the result of global conflict or simply poor transmission planning. In the process of fixating on short run inflation outcomes, as the Fed was liable to do in the past few years, the costs to maximum employment and longer run price stability could compound, especially under a less favorable demand backdrop.
Productive Capacity Is Central to Both Sides of the Mandate
Stable prices and maximum employment aren’t just outcomes of aggregate demand — they depend fundamentally on the productive capacity of the economy. Prices depend not just on how much people want to buy, but how much the economy can sustainably produce.
Yet current Fed thinking tends to treat productive capacity as fixed, slow-moving, and independent of monetary policy. This view fails to recognize when supply shocks may interfere with monetary policy decisions and how monetary policy may interact with long-term supply side processes. In reality, longer-term productivity growth depends on fixed capital formation and innovation, which in turn is responsive to financial conditions. Supply and demand are not independent; productivity growth reacts dynamically and favorably to full employment and expectations of stable future demand.
Given the cyclicality, interest rate sensitivity, and policy uncertainty affecting housing, manufacturing, and energy investment, the Fed would be wise to recognize the accumulating supply-side risks in those sectors, and limit the risk of data misreads and policy mistakes in response.
The Benefits of a Supply-Aware Monetary Policy
Not all inflationary developments require the same monetary policy response. Since the Fed’s interest rate tools primarily affect inflation through its effects on aggregate demand, inflation that happens because of supply shocks does not warrant the same tightening response that would be appropriate if inflation were caused by accelerating consumer demand.
When monetary policy treats every inflation uptick the same way — by raising interest rates — it may miss underlying demand deterioration or else risk suppressing the very investments that would help relieve inflation pressures over time. Tight credit supply can prolong a pre-existing housing or energy shortage, leaving consumers vulnerable to higher prices in the short and longer run.
As Fed officials themselves will tell you, the primary challenge to this view is that it is difficult to disentangle supply-driven and demand-driven inflation in real-time. This is especially true when aggregate inflation indices are the primary tool the Fed uses to guide its policy decisions. The reliance on inflation targeting has led the Fed to jump from one inflation subaggregate to another in, ultimately confusing both policy and communications.
A supply-aware policy posture should:
- Distinguish more effectively between price inflation that may persist due to robust consumption demand growth and price inflation more consistent with supply dislocations.
- Avoid interfering with capital formation where relevant to addressing longer run price stability and sustainable employment maximization.
The Case for Nominal Aggregates as Complementary Communication Tools
One way to address these challenges is to supplement the Fed’s inflation targeting with nominal aggregates that provide clearer real-time signals about demand pressures relevant to the Fed’s inflation gauge, the deflator for consumer spending (Personal Consumption Expenditures):
- Gross nominal labor income growth (cumulative wage and employment growth) gives insight into consumer purchasing power.
- Nominal consumer spending growth reflects the pace of actual demand-side activity.
These indicators help distinguish between inflation driven by demand and inflation driven by cost or supply shocks. When the business cycle and labor markets are fragile, we typically do not see inflation coincide with robust labor income or consumer spending growth. When they are stronger, as they were in 2022, the presence of inflation can take on firmer persistence. Focusing on nominal labor income and consumer spending, instead of just GDP in totality, also avoids penalizing investment-led GDP growth, which can add to supply over time and is less relevant to consumer demand and consumer price inflation.
Tracking these aggregates does not require abandoning the inflation target — but they provide a more coherent lens through which Fed officials can communicate and the public and market participants can communicate medium and longer run inflation goals.
Revisions to the Fed’s “Consensus Statement” For A More Supply-Aware Monetary Policy
Revision #1: Recognize the Role of Supply-Side Disturbances
The Consensus Statement emphasizes the role of economic and financial disturbances that cause employment, inflation, and interest rates—the three stated Congressional objectives in Section 2A of the Federal Reserve Act. While economic and financial disturbances can be interpreted to focus on demand-side phenomena, the statement should be augmented to clarify that shocks on the supply side, whether to existing or future capacity, also shape labor market, inflation, and long-term interest rate outcomes.
Suggested Additions To Current Statement:
“Employment, inflation, and long-term interest rates fluctuate over time in response to economic and financial disturbances, including disturbances in productive capacity and investment conditions. Monetary policy plays an important role in stabilizing the economy in response to these disturbances.”
Revision #2: Recognizing Monetary Policy’s Influence on the Supply Side
Exogenous developments, whether to the financial system or to the supply side of the economy, can heighten unique tradeoffs between monetary policy and productive capacity. The language discussing financial disturbances and the stability of the financial system reflect an understanding of how financial dynamics can weigh on real economic outcomes, and in a manner missed by simple comparisons of current inflation and labor market outcomes. Such language should be buttressed with a recognition that the dynamics shaping the productive capacity of the US economy warrant similar treatment. Just as a financial crisis may cause employment and output to drop precipitously despite latent disinflationary effects, supply side forces can have a more pronounced effect on inflation while still warranting a more forward-looking approach from policymakers.
Suggested Replacement To Current Statement:
“The Committee’s primary means of adjusting the stance of monetary policy is through changes in the target range for the federal funds rate. The Committee’s policy decisions must be informed by the varying effects of monetary policy on the productive capacity of the economy through financial disturbances, the stability of the financial system, and changes in investment conditions. Shortfalls in productive capacity can affect inflationary pressures over an extended period. The Committee considers such dynamics in their assessment of appropriate monetary policy.”
Revision #3: Communicating The Inflation Target Through Nominal Aggregates
The Fed should codify in its Consensus Statement that nominal aggregates will be the main lens through which it assesses underlying trends, the outlook, and risks to achieving the Fed’s 2% inflation target over time. Nominal consumer spending growth very directly relates to the demand-side pressures on the prices that compose the PCE deflator, the Fed's primary inflation gauge. Nominal gross labor income growth captures the proximity performing at maximum employment and is well-correlated with (and causally related to) nominal consumer spending growth.
Suggested Additions to Current Statement:
The Committee reaffirms its judgment that inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. In pursuing inflation at that rate over the longer run, the Committee will consider a variety of measures of growth in nominal aggregate consumption expenditures and nominal gross labor income, and communicate to the public accordingly. The Committee judges that longer-term inflation expectations that are well anchored at 2 percent foster price stability and moderate long-term interest rates and enhance the Committee’s ability to promote maximum employment in the face of significant economic disturbances.
Revision #4: If A Stable Financial System Matters, So Do Stable Supply Conditions
The Consensus Statement places special emphasis on the stability of the financial system and the vulnerability of the dual mandate objectives to financial shocks. The adverse effects on productive capacity on short run inflation and labor market outcomes are less discussed even though they can overwhelm monetary policy’s effects over multiple years.
Suggested Additions to Current Statement:
“Monetary policy actions tend to influence economic activity, employment, prices, and investment with a lag. In setting monetary policy, the Committee seeks over time to mitigate shortfalls of employment from the Committee’s assessment of its maximum level and deviations of inflation from its longer-run goal. Moreover, sustainably achieving maximum employment and price stability depends on a stable financial system and capacity conditions. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system and productive capacity that could impede the attainment of the Committee’s goals for an extended period of time.”
Conclusion: A Framework Built for The Next 5 Years
The Fed has the chance to strengthen its credibility and policy effectiveness by building a framework that meets the challenges that monetary policy will face in the coming years. That means recognizing that inflation can rise for reasons beyond the Fed’s direct control and may not reflect underlying demand conditions. In these cases, the Fed’s traditional inflation-fighting tools can sometimes worsen the problem.
By grounding policy in an empirical understanding of supply-side dynamics and anchoring its communication to observable nominal aggregates, the Fed can pursue its mandate more effectively — and build broader public trust in the process.