Richard Clarida on FAIT, R-Star, and the Future of the Fed's Framework

Episode Summary

Executive Summary: David Beckworth interviews Richard Clarida about his career in macroeconomics, his role in shaping New Keynesian monetary policy, and his policy work at the CEA, Treasury, the Fed, and PIMCO. Clarida explains how his research bridged theory and practice, defends flexible average inflation targeting as an evolution of Fed practice, and argues that post-pandemic inflation reflected global shocks and initial conditions more than FATE itself.

Main Topics: Clarida’s path into economics and macro (Priority: 5/5): Clarida traces his interest in economics to an influential undergraduate macro class at Illinois, then explains how mentors like Matt Canzneri and Thomas Sargent shaped his focus on rational expectations, international macro, and sticky-price models. Building New Keynesian monetary policy analysis (Priority: 5/5): He recounts how he, Mark Gertler, and Jordi Gali pushed macro research toward systematic policy rules, especially Taylor-rule-based models, and away from purely shock-driven VAR approaches. Policy experience across administrations and institutions (Priority: 4/5): Clarida discusses lessons from the Reagan CEA, George H.W. Bush Treasury, and later PIMCO, emphasizing the gap between textbook economics and the realities of policymaking, including nowcasting and real-time decision-making. Fed vice chairmanship and the framework review (Priority: 5/5): He describes the privilege and responsibility of serving under Chair Jay Powell, the collegial culture of the Eccles Building, and his role in the Fed’s 2018-2020 framework review and communications work. Flexible average inflation targeting (FATE) (Priority: 5/5): Clarida presents FATE as an evolution, not a revolution: keep 2% inflation, anchor expectations, acknowledge lower-bound constraints, and use temporary overshoots after persistent shortfalls to re-anchor expectations. Post-pandemic inflation and accountability (Priority: 4/5): He argues the inflation surge was driven by common global shocks and similar policy reactions across advanced economies, making it misleading to blame FATE alone without considering counterfactuals and cross-country evidence. r-star, term premia, and the future level of rates (Priority: 4/5): Clarida distinguishes between the short policy rate and long-term bond yields, arguing bond yields may stay higher because of term premia and fiscal debt supply, even if the long-run funds rate remains relatively low.

Key Arguments: Clarida’s academic work emerged from a desire to make macroeconomics operational and policy-relevant, especially under rational expectations and sticky prices. The early 1990s dominant VAR approach was too agnostic about systematic policy behavior; Taylor-rule-based analysis gave a better account of how central banks actually behaved. The science of monetary policy research program was risky because it challenged both econometric convention and the prevailing view that policy should focus narrowly on money growth or shocks. Nowcasting was valuable because policymakers needed current economic assessment before lagged GDP data arrived; Treasury successfully applied it after 9/11. FATE was designed to address a world in which the lower bound constrained policy and inflation persistently undershot 2%, not to abandon the 2% target. A key implementation choice was forward guidance, but Clarida separates the framework itself from the specific tools used to implement it. Post-pandemic inflation should be evaluated against counterfactuals; if many central banks with different frameworks produced similar outcomes, the episode likely reflects shared shocks more than one framework error. The most relevant future question is not whether the 2% target should change, but whether the lower bound remains as binding as it once appeared and how expectations are anchored going forward. The long-term neutral policy rate may still be low, but long-term bond yields can be higher because of higher term premia and a larger supply of government debt.

Data Points: Macro Musings archive size: 400+ episodes - Used to power the new Macro Muse Bot chatbot Clarida’s Harvard PhD timeline: 1979-1983 - He entered Harvard at age 22 and left four years later at age 26 University lecture size: 600 students - Clarida recalls his first principles of economics class at Illinois Harvard/Yale policy and academic time: 1980s-1990s - Period when Clarida developed his rational expectations and sticky-price macro work Journal of Economic Literature paper: 1999 - ‘The Science of Monetary Policy: A New Keynesian Perspective’ with Gertler and Gali QJE paper: 2000 - ‘Monetary Policy Rules and Macroeconomic Stability: Evidence and Some Theory’ European Economic Review paper: 1998 - ‘Monetary Policy Rules and Practice and International Evidence’ Treasury nowcasting implementation: 2-3 months - Treasury team built a rough nowcasting system after 9/11 Q4 2001 GDP nowcast: Flat / zero growth - Treasury’s nowcast contrasted with Wall Street pessimism after 9/11 Consensus forecast for Q4 2001 GDP: -4% to -6% - Wall Street expectations discussed in the Treasury nowcasting anecdote Fed funds rate at liftoff period: 2.4%-2.5% - Clarida describes the economy as near equilibrium when rates reached this level in 2018 Fed framework adoption: August 2020 - Flexible average inflation targeting announced at the virtual Jackson Hole meeting Framework review staffing: A dozen+ staff work streams - Clarida describes the review as a system-wide effort across the Fed ZLB era reference: December 2008 to December 2015 - Rates were at zero while core inflation averaged about 1.5% Core inflation during ZLB period: 1.5% - Illustrates why FATE emphasized persistent undershooting Pandemic GDP shock: -30% annual pace - Second quarter of 2020 collapse cited in discussing forward guidance Pandemic unemployment rate: 14% - Level referenced when explaining the September 2020 guidance Fiscal support during pandemic: $2.5 trillion - CARES Act and related support to aggregate demand Fed rate liftoff under Powell: March 2022 - Clarida says this was later than rule-based counterfactuals suggested Rule-based counterfactual liftoff: Fall 2021 - Referenced as the timing implied by policy rules and SEP-based counterfactuals Treasury debt-to-GDP ratio in 2001-03: 39% - Clarida compares this to today’s higher debt load when discussing term premia Current U.S. debt-to-GDP ratio: 100+% - Used to argue that higher term premia may be needed to clear Treasury markets

Pivotal Quotes: "I want to do rational expectations macro. And in particular, I want to do sort of international macro." — Richard Clarida: Describing the intellectual direction he set when applying to graduate school "We were very early in that. And certainly at the time we were doing it, we certainly knew of this work. But this work ... had not yet taken a stand that the third equation would be a Taylor Rule equation." — Richard Clarida: Explaining the novelty of the Clarida-Gertler-Gali monetary policy-rule framework "Flexible average inflation targeting is ... an evolution, not a revolution, of existing practice." — Richard Clarida: Defending the Fed framework review and the logic behind FATE

Implications: Clarida’s interview frames modern central banking as rule-informed but flexible, with the main challenge now being how to keep inflation expectations anchored while navigating higher debt, uncertain r-star, and possible future lower-bound risks.