Major policy shift at U.S. Federal Reserve
Federal Reserve Chair Jerome Powell unveiled a new approach to setting U.S. monetary policy, letting inflation and employment run higher in a shift that will likely keep interest rates low for years to come.
Following a more than yearlong review, Powell said Thursday that the Fed will seek inflation that averages 2 per cent over time, a step that implies allowing for price pressures to overshoot after periods of weakness. It also adjusted its view of full employment to permit labor-market gains to reach more workers.
The new strategy, outlined by Powell in a speech delivered virtually for the central bank’s annual policy symposium traditionally held in Jackson Hole, Wyoming, is being undertaken to tackle years of too-low inflation. It hands the central bank flexibility to let the job market run hotter and price pressures float higher before taking action as it may previously have done.
“They really, really, really are not going to be raising interest rates any time soon,” said James Knightley, chief international economist at ING Financial Markets. “The Fed is saying rates will be lower for longer, but don’t worry inflation is not going to be picking up.”
While it doesn’t target a specific rate of unemployment broadly or for certain demographic groups, the approach may help address other weaknesses in the economy.
“Maximum employment is a broad-based and inclusive goal,” Powell said. “This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.”
During the longest U.S. economic expansion on record until the pandemic hit earlier this year, many groups benefited -- including minorities and women. With millions out of work and unrest flaring up across the U.S. over racial inequality, questions about how the Fed’s policy helps diverse communities have been raised.
Achieving an overshoot of inflation in the near term will be difficult. Unemployment is above 10 per cent, and the economy is still recovering from the shock of virus shutdowns that inflicted the steepest recession on record.
Powell’s speech left the matter of how tactically they would aim for higher inflation for future Federal Open Market Committee meetings. With the new strategy in place, Goldman Sachs Chief Economist Jan Hatzius said he now expects “changes to the forward guidance and asset purchase program to come at the September” policy meeting.
St. Louis Fed chief James Bullard later said in an interview on Bloomberg Television with Michael McKee that “we’re going to try to make up for past misses,” but judgments about how to do so were for policy maker and there are different opinions around the table.
“If you wanted to stay on the price-level path that was established from 1995 to 2012 you could run 2.5 per cent inflation for quite a while,” he said.
In the new statement on longer-run goals, the Fed said its decisions would be informed by its assessment of “shortfalls of employment from its maximum level.” The previous version had referred to “deviations from its maximum level.” The change de-emphasizes previous concerns that low unemployment can cause excess inflation.
While expected, the announcement of the strategy shift came sooner than some thought. After first fluctuating on the news, U.S. stocks resumed their record-breaking rally and the Treasury yield curve steepened to the widest in two months as traders bet policy rates will remain locked near zero for even longer.
Calling the revised strategy “a robust updating,” Powell said that after periods when inflation has been running below 2 per cent, monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time.
What Bloomberg Economics Says
“Had the Fed adopted average inflation targeting -- with the inflation rate calculated over a one-year window -- in the last economic cycle, the first rate hike after the Great Recession would have been pushed back to 2018 instead of late 2015.
-- Yelena Shulyatyeva and Eliza Winger, Click here for the full report
The shift he announced is a product of an unprecedented review of the Fed’s strategies, tools and approach to communications that began in early 2019. Fed officials said they will now conduct such reviews about every five years.
Since the central bank officially set its inflation target at 2 per cent in 2012, the Fed’s preferred measure of price increases has consistently fallen short of that objective, averaging just 1.4 per cent.
That challenge was part of the impetus for the strategy review. Low inflation contributes to low interest rates, which reduces the Fed’s ability to fight off economic downturns -- potentially making them deeper and longer. Indeed, the strategy document pointed out that this limitation on their policy rate means “downward risks to employment and inflation have increased.”
“Powell is not only saying that they will be more patient in removing the punch bowl in the future, he has changed the recipe for the punch,” said Mark Vitner, senior economist at Wells Fargo & Co. “While the timing comes slightly earlier than had been expected, the Fed is far better served to under-promise and over-deliver, or deliver earlier in this case.”
Even so, the document leaves the Fed ample room to fight a run up in inflation. Powell noted the risk, saying that “if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal,” the central bank wouldn’t hesitate to act.
Fed officials also altered the strategy document to include a section acknowledging that financial stability can also affect their ability to reach their longer-run goals.
“Sustainably achieving maximum employment and price stability depends on a stable financial system,” it said. “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 that could impede the attainment of the committee’s goals.”
Powell has emerged an unexpected change agent in the role of chairman. While he isn’t a Ph.D. economist, his first speech at Jackson Hole in 2018 discussed the risks and uncertainties around the basic parameters of policy making.
As President Donald Trump’s pick to helm the central bank, he engaged the Fed in a dialogue with moderate- and low-income communities across the U.S. and steered the economy toward lower rates of unemployment that benefited Black and Hispanic communities.
He aggressively expanded the Fed’s emergency lending authority as the coronavirus took hold in March, slashing rates to zero, and extending aid to municipalities, small- and medium-sized companies as well as large corporations.