Fed changes its approach to inflation, as leaders aim to navigate future crises and reach full employment

Speaking at the Fed’s yearly economic policy symposium in Jackson Hole, Wyo., Powell emphasized achieving full employment. As the Fed debuted a long review of its monetary policy framework, the Fed concluded that inflation could temporarily run a bit over its 2 percent target if that means more Americans stay in the workforce.

“Our revised statement reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities, and that a robust job market can be sustained without causing an unwelcome increase in inflation,” Powell said in a statement.

In the years before the pandemic, the Fed grappled with how the unemployment rate could continue to fall without triggering an unwelcome rise in prices. Now, the Fed is officially signaling that employment can run stronger without setting off unwanted spikes in inflation. Practically, that means the Fed wouldn’t increase rates or brace for a rise in inflation even as employment levels strengthen.

Markets rallied on Powell’s announcement, which spurred a 200-point rise in the Dow Jones industrial average and helped erase the Dow’s losses from this year.

Also, after the Great Recession, Fed leaders worried that as interest rates trended downward, the central bank would be left with less room to slash rates to zero in the event of another downturn. At the same time, central bank leaders worried about what to do about inflation persistently staying below the 2 percent target. Striking the right balance between interest rates and inflation is key to fostering an economy that grows at a steady pace and keeps Americans securely employed.

“With interest rates generally running closer to their effective lower bound even in good times, the Fed has less scope to support the economy during an economic downturn by simply cutting the federal funds rate,” Powell said. “The result can be worse economic outcomes in terms of both employment and price stability, with the costs of such outcomes likely falling hardest on those least able to bear them.”

When it comes to price stability, the Fed’s old rule book dictated that the moment inflation topped the 2 percent threshold, the Fed would quickly raise rates to bring inflation back down. Now, the Fed is adopting a form of average inflation targeting, which essentially means that the Fed will allow for some overshoot of the 2 percent target to balance out periods when inflation skirted below. Those overshoots will be moderate, Powell noted Thursday and aren’t intended to last a long time.

“This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” Powell said in his Jackson Hole speech.

Powell announced that the Fed would undertake a broad review of its monetary policy in November 2018. Last year, Fed leaders traveled the country for “Fed Listens” events to gauge how monetary policy was affecting the lives of workers groups, small-business owners, low- and moderate-income communities, and others. In a question-and-answer session after his speech, Powell said that the review allowed the Fed not only to sharpen its understanding of what brings people into the workforce and keep them there, but to arrive at those answers with public input and transparency.

Back then, the Fed thought it was planning for a vastly different economy, one with historically low levels of unemployment and an economic expansion that was still running hot. Then the coronavirus outbreak and recession began, kicking tens of millions of Americans out of the workforce, forcing the Fed to quickly slash rates to zero and raising looming questions about the economy’s future.

The changes to the Fed’s thinking “explicitly acknowledge the challenges for monetary policy posed by a persistently low interest rate environment,” a Fed news release read. “Here in the United States and around the world, monetary policy interest rates are more likely to be constrained by their effective lower-bound than in the past.”

In dealing with the current recession, Fed leaders have said interest rates will stay at zero for some time. That could undermine how exactly the Fed can achieve higher inflation. Some economists are concerned that keeping rates low and setting the expectation that they will stay that way, could undermine the effectiveness of those tools and make it harder for inflation to climb.

The sudden recession has also put new pressure on the Fed to shepherd a recovery that lifts all Americans and narrow persistent racial and economic gaps. There’s no expectation that the Fed can heal the economy alone, and Congress still is deadlocked over another wave of stimulus. But the crisis, and the run-up to Thursday’s announcement, have fueled a fresh examination of exactly what the Fed’s mandate means.

Having a firmer understanding of full employment is also key to reducing inequality, Powell said. For many minority and low-income communities, the benefits of the economic expansion did not arrive until much later in the years after the recession, and many of those gains were wiped clean during the current crisis.

Yet even the Fed’s new approach can’t change the fact that the central bank’s tools are blunt. Interest rates affect broad swaths of the economy, and the Fed is not set up to home in on certain segments of the population. In many cases, Powell said that “there are better tools held by elected officials” to address longstanding gaps.

“It needs to be an all of government, all of society kind of thing,” Powell said. “We’re going to keep doing what we can do. We really need it to be broader than just the Fed.”

On top of slashing rates to zero, the Fed has also taken broad steps to flood the markets with liquidity and roll out emergency lending programs for struggling local governments and midsized businesses. It’s unclear what the long-term effect of the moves will be, or when the Fed will be able to shut down those backstops. Powell and other Fed leaders have emphasized for months that a stable recovery will depend on controlling the virus and have repeated that more aid from Congress may be needed.

The Fed on Thursday also announced it would conduct a public review of its monetary policy tools and strategy about every five years.

Heather Long contributed to this report.

Source:WP