The Feds New Direction

The Federal Reserve has announced a significant policy shift in its approach to inflation and in how it will consider other economic metrics. Practically speaking, the shift indicates the Fed moving forward will be less inclined to increase interest rates when the unemployment rate falls, as long as inflation isn’t on the rise. 

In remarks delivered virtually, Federal Reserve Chairman Jerome Powell  said, “Many find it counterintuitive that the Fed would want to push up inflation. However, inflation that is persistently too low can pose serious risks to the economy.”

The Fed said it is looking at averaging 2% inflation over time, a departure from its annual goal of 2%.

Powell said the Fed is moving to a position of making  job growth pre-eminent and will not raise interest rates to guard against coming inflation just because the unemployment rate is low.

In fact, said Powell, the Fed will look to tolerate slightly faster consumer price increases if the labor market is strong or strengthening.

What that means is extended low-interest rates, including on mortgages and business loans, according to analysts.

Market Response

• The New York Times reported “market reaction to Mr. Powell’s announcement was mixed. Investors had already penciled in years of rock-bottom interest rates and analysts will be watching for more concrete rate guidance at the Fed’s upcoming meetings.”
• The Times’ analysis further noted the central bank is “facing major long-run challenges as price gains prove tepid and as interest rates have slipped lower across  advanced economies including the United States, leaving Fed officials with less room to cut borrowing costs and coax higher growth following recessions. Those slow-burn problems are what prompted Mr. Powell and his colleagues to revamp their policy framework. At the same time, the coronavirus pandemic has created a a significant short-run threat, shuttering businesses and costing millions of people their jobs.”
• Former Fed Chairman Janet L. Yellen said, “It seems like a pretty subtle shift to most normal human beings. (But) most of the Fed’s history has revolved around keeping inflation under control. This really does reflect a decisive recognition that we're in a very different environment.”
• “The Fed is announcing this policy framework in part to push up inflation expectations,” Seth Carpenter, a former Fed research official now at UBS, told the Times. “In practice, however, getting above 2% is a long way off.”
• If investors believe the Fed’s words are credible, the changes announced Thursday “will increase the accommodative power of policy,” former Fed Chairman Ben Bernanke told the Wall Street Journal. “When you go into a recession, markets will expect a longer period of easier policy and that will, in turn, increase the amount of effective stimulus…They believe, and I agree, that there are substantial social benefits from a strong labor market. Under this strategy, they will not take any steps to cool the labor market unless there is clear evidence of inflationary pressure.”
• The Journal further reported, “The revamp also set the table for the Fed to provide more specifics about how long it expects to keep interest rates low as soon as its Sept. 15-16 meeting. It could do that by putting forward an inflation threshold and a qualitative description of labor market conditions that would warrant higher rates.”

Important Changes Already Happened

• “The important changes have really already happened,” William Dudley, who was president of the New York Fed from 2009 to 2018, told the Wall Street Journal. “People already know the Fed wants to see inflation above 2%. This is a recognition of something that has been pretty implicit for a while.”
• Some critics offered a warning to the Journal that the changes would do little to boost growth and instead would propel asset prices to higher levels, creating financial instability. Others had recommended even bolder steps, such as raising the inflation target, to avoid the low-inflation trap that has hampered central banks in Japan and Europe.
• The Journal noted the Fed is committing to stay off the brake pedal for longer, but Powell said little Thursday about any additional tools the Fed might deploy to press harder on the gas. “They’re not good at pushing on the gas. We’ve seen that for 20 years in Japan,” Adam Posen, president of the Peterson Institute for International Economics, told the Journal. “They can’t force people to buy durable goods. They can’t force banks to lend. They can’t force companies to invest.”
• “The Fed is playing a hand of cards that is missing some of the face cards. It is dealt on a routine basis a less powerful hand of cards,” David Wilcox, a former top Fed economist, told the Journal. “It behooves the Fed to play its hand as well as it possibly can.”