Chair Jerome Powell announced this morning that the Fed will be adopting what he described as a “flexible form of average inflation targeting”, which we expect will trigger additional policy stimulus in the form of stronger forward guidance and possibly additional asset purchases too. But, with long-term interest rates already very low and the Fed still ruling out negative rates as undesirable, we don’t expect that additional stimulus to provide any significant boost to the real economy. That means the Fed might struggle to hit its 2% inflation rate at all, let alone deliver above-target inflation.
- Chair Jerome Powell announced this morning that the Fed will be adopting what he described as a “flexible form of average inflation targeting”, which we expect will trigger additional policy stimulus in the form of stronger forward guidance and possibly additional asset purchases too. But, with long-term interest rates already very low and the Fed still ruling out negative rates as undesirable, we don’t expect that additional stimulus to provide any significant boost to the real economy. That means the Fed might struggle to hit its 2% inflation rate at all, let alone deliver above-target inflation.
- The Fed updated its long-term strategy and goals statement this morning, to reflect that shift in the framework. The statement now notes the FOMC “seeks to achieve inflation that averages 2% over time” and that “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” Given that inflation has been running slightly below target for most of the past decade that suggests, in Powell’s own words, the Fed will now be targeting a rate “moderately above target for some time.” The policy is deliberately vague, however, with Powell not quantifying exactly what “excessive inflationary pressures” would make FOMC officials uncomfortable.
- In another major change, the Fed will now interpret its maximum employment goal as a “broad-based and inclusive goal”, which means that rather than focusing solely on aggregate labour market outcomes, officials will also take into account how low-income and minority labour market participants are faring. Although that shift in focus is hard to disagree with, we do wonder whether the modern-day Fed is at risk of repeating the “anguish of central banking”, as originally described by ex-Fed Chair Arthur Burns in his infamous speech in the late 1970s. Burns’ argument was that he and other central bankers had the tools to control inflation in the 1960s and 1970s, but chose not to do so because “the Fed was itself caught up in the philosophic and political currents that were transforming American life and culture”. As Burns learned to his cost in the 1970s, the less focus the modern-day Fed puts on controlling inflation, the bigger the risk is that inflation will eventually get out of control.
- Finally, the last major change is that, in an acknowledgement that the Phillips curve is much flatter now, the Fed will focus on “shortfalls” rather than “deviations” in employment from its maximum level. The upshot is that the Fed won’t pre-emptively raise interest rates if the unemployment rate falls below estimates of the long-run equilibrium rate unless that decline is accompanied by actual signs of inflation. This is a complementary change to the average inflation target which, according to Powell “reflects our view that a robust job market can be sustained without causing an outbreak of inflation.”
- Now the Fed has implemented the changes to its policy framework, officials need to decide whether that warrants any additional stimulus. From the minutes of the last FOMC meeting, officials appear to be close to agreeing on stronger forward guidance – either calendar- or outcome-based, and we wouldn’t be surprised if those changes are accompanied by a new program of large-scale asset purchases too. We discussed those potential changes in depth here.
- Neither the introduction of an average inflation target, nor the adoption of stronger forward guidance – even if combined with additional asset purchases – will have any dramatic impact, however, because yields are already incredibly low across the curve. Adopting a negative policy rate might have more of an impact on long-term interest rates, but Fed officials believe the costs outweigh the benefits of such a policy and we don’t expect them to reconsider that position any time soon. The bottom line is that monetary policy is approaching its limits and, while Fed officials would never admit that publicly, that explains why they have become so outspoken in encouraging Congress to put more fiscal stimulus in place.
Paul Ashworth, Chief US Economist, email@example.com