Fed Chairman Jerome Powell unveiled the updates in a speech set for delivery at a virtual symposium on 27 August, the most ambitious revamp of the Fed policy-setting framework since it was first approved in 2012. The practical effect is that it may be a very long time before the Fed considers raising interest rates.
Powell said the changes reflected lessons the central bank officials had learned in recent years about how inflation didn’t rise as anticipated when unemployment fell to historically low levels.
“It reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” said Powell.
The Fed had been moving in this direction over the last 18 months, a point made clear in early 2019 when officials abruptly abandoned plans to continue lifting interest rates. Powell initiated a policy-setting strategy review in late 2018, motivated by the sobering probability that central banks around the world will face greater difficulty than in the past to spur growth due to low levels of interest rates.
The coronavirus pandemic-induced recession brought those challenges into stark relief. The Fed cut its benchmark rate twice in March to near zero from a range between 1.5% and 1.75%, and it has bought trillions of dollars of government assets to stabilise markets.
The Fed enshrined the conclusions of its yearlong strategy review on Thursday by formally approving a revamp of the central bank’s statement on longer-run goals and monetary policy strategy. Powell secured agreement on those changes from all 17 officials who participate in the Fed’s rate-setting committee deliberations.
For years, the Fed justified plans to slowly withdraw stimulus by warning that waiting too long to do so could provoke an acceleration of price pressures, particularly as the unemployment rate fellow below a level estimated to push prices higher, sometimes referred to as the natural rate of unemployment.
The new statement approved Thursday said decisions to raise interest rates would be guided by shortfalls of employment from its maximum level, rather than saying they would be guided by deviations. In other words, the Fed signalled that it wouldn’t raise interest rates simply on the basis of a forecast that inflation will rise, but instead would wait to see evidence that inflation was at the central bank’s 2% target.
The Fed believes the economy runs best when businesses and consumers behave as if inflation will even out over time despite short-run ups and downs. Fed officials seek 2% inflation because they see it as consistent with healthy growth.
While the Fed didn’t change its inflation target, it made an important and widely anticipated shift by stating that if inflation runs below 2% following economic downturns, it will seek to hold longer-term inflation expectations steady by seeking periods of inflation above 2% when the economy is stronger.
“The Committee seeks to achieve inflation that averages 2% over time, and therefore judges that, following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation immediately above 2% for some time,” the statement said.
Powell said the central bank was “not tying ourselves to a particular mathematical formula that defines the average,” and he characterised the shift as a “flexible form of average inflation targeting.”
When the Fed formally adopted its 2% inflation target in 2012, short-term rates were pinned near zero, as they are today. But central bankers, economists and investors largely expected those rates to return over time to more normal levels of 4% or so once the economic expansion matured.
Even before the pandemic hit, those rates were stuck at much lower levels than 4% for reasons that weren’t expected to change soon, such as demographics, globalisation, technology and other forces that have held down inflation.
Meantime, the Fed had described its 2% target in recent years as symmetric, meaning 2% wasn’t a ceiling. Under the approach, the Fed wasn’t taking past misses of the target into account.
The problem for some officials is that except for a brief period in 2018, inflation ran below the target but never above it. While those misses were relatively small, Powell said they were concerning because failing to achieve the target could lead to harmful declines in businesses’ and consumers’ expectations of future inflation.
“The persistent undershoot of inflation from our 2% longer-run objective is a cause for concern,” Powell said on 27 August. While it might be counterintuitive for the Fed to desire more inflation, particularly given rising costs for certain items like housing, Powell said the Fed needed to avoid “an adverse cycle of ever-lower inflation and inflation expectations.”
The dynamic is particularly troubling because expected inflation feeds directly into the general level of interest rates, he said. Lower inflation deprives central banks with already-low interest rates of tools to counteract downturns.
“We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome,” said Powell. “We want to do what we can to prevent such a dynamic from happening here.”
Source: Wall Street Journal
