“[E]mployment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals.” Federal Reserve Chairman Jerome Powell, “New Economic Challenges and the Fed’s Monetary Policy Review,” Webcast speech to Federal Reserve Bank of Kansas City Jackson Hole Symposium, August 27, 2020.
On August 27, marking the conclusion of the Fed’s first strategic review, the Federal Open Market Committee released an amended version of their fundamental policy guide—the Statement on Longer-Run Goals and Monetary Policy Strategy. The FOMC adopted a form of flexible average inflation targeting (FAIT). Partly because the new strategy largely confirms recent Fed behavior, the response in financial markets was minimal (see red bars in chart below), just as it was when the Fed first introduced inflation targeting in 2012 (black bars). Indeed, market-based long-run inflation expectations were virtually unchanged this week. Perhaps the only noticeable development was a modest steepening at the very long end of the yield curve.
One-Day Changes in Financial Market Conditions (basis points, except where noted), August 27, 2020 and January 25, 2012
Sources: FRED and (for the 2020 U.S. dollar index futures) investing.com.
In this post, we identify three key factors motivating the Fed review and highlight three principal shifts in the FOMC’s strategy. In addition, we identify several critical questions that the FOMC will need to answer as it seeks to implement the new policy framework. Specifically, the shift to FAIT implies a change in the Committee’s reaction function. How does this reformulated objective influence the FOMC’s systematic response to changes in economic growth, unemployment, inflation and financial conditions? Under FAIT, the effective inflation target over the coming years also now depends on past inflation experience. What is that relationship?
Perhaps the greatest motivation for the Fed’s new thinking is the realization that the sustainable level of nominal interest rates has declined. This shift is visible in the FOMC’s declining projections for the longer-run federal funds rate (see our earlier post). As a result, central bankers worry that the policy rate will be stuck at its effective lower bound (ELB) with some frequency, limiting the Fed’s conventional policy space. The notion is that FAIT effectively raises the inflation target when inflation is low. By lowering the expected real interest rate in these circumstances, FAIT reduces the need for using forward guidance and balance sheet tools at the ELB (see our earlier post).
Second, as Chairman Powell highlights in the opening quote, the link between the labor market and inflation is looser than it once was, making it difficult to estimate the level of unemployment consistent with price stability.
Third, for the most part, inflation has run below 2% since 2012 when the FOMC first stated their quantitative target. (Depending on the price index, inflation has averaged between 1.3% and 1.8% per year over the past eight years.) With persistently sub-target inflation, the concern is that inflation expectations will fall, raising expected real interest rates and effectively tightening financial conditions, especially when the policy rate is near zero. As Chairman Powell highlighted, “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 reverse.”
Combining these three factors, the FOMC saw a need to address the fundamental asymmetry of conventional monetary policy: when inflation rises above target, policymakers can raise interest rates, dampening demand and driving inflation back to target. However, if inflation is too low, when the policy rate is at its lower bound, conventional policy is no longer available to further stimulate demand, raise inflation, and ensure inflation expectations remain well anchored. The experience of recent years in the United States and abroad has raised the Fed’s concern about these downside threats.
So, what are the principal changes to the FOMC’s Statement on Longer-Run Goals?
We highlight three:
Introduction of flexible average inflation targeting (FAIT)
Downgrading of efforts to pre-empt rising inflation
An explicit commitment to undertake a thorough public review of the monetary policy framework “roughly every five years.”
The first of these aims to address the persistent shortfalls in inflation relative the 2% target. The second acknowledges that the Fed’s ability to forecast inflation is limited, formalizes the reduced concern about tight labor markets, and raises the relative importance of meeting the Fed’s employment mandate relative to the price stability mandate. The third provides a time horizon for re-assessing the adequacy of the FOMC’s policy framework. Focusing on the first two, the changes create an explicit asymmetry that favors higher average inflation in an effort to counter the fundamental asymmetry inherent in conventional interest rate policy.
We discussed average inflation targeting in some detail in our previous post (see here). The Fed’s “flexible” version leaves it considerable policy discretion. Rejecting any “formula,” the approach defines neither the past time window for measuring inflation deviations nor the future time window for restoring inflation to its target average. Absent such key details, the FOMC will need to communicate their short-term inflation goal from meeting to meeting. The Committee’s ability to influence inflation expectations at the lower bound—a key rationale for adopting FAIT—will depend on how clearly they are able to communicate this goal and how credible their commitment is to achieve it. The more specific the statement is (about the inflation objective and the time horizon), the more effective it will be in lowering expected real interest rates when the policy rate is at its lower bound.
At the same time, the new Statement leaves open important questions about what would trigger a change in the near-term inflation objective. For example, if inflation or inflation expectations were to rise to 3%, would that be sufficient to prompt a shift? While FAIT aims to make the long-run price level more predictable, how much near-term variation in inflation will the FOMC tolerate?
To take a simple example, over the past five years, the shortfall in inflation relative to a 2% objective is a cumulative 2.5 percentage points (measured by the price index of personal consumption expenditures). If the FOMC desires to make that up over the next five years—aiming at a 10-year average of 2%—then they would need to aim at inflation of 2.5% on average. Alternatively, if they want to make up the shortfall more quickly, say over 3 years, then the target would have to be closer to 3%. The more clearly the FOMC reveals their reaction function—including the horizon over which they intend to restore inflation to the longer run 2% objective—the more likely it is that their actions will prove stabilizing.
Regarding the downgrading of efforts to pre-empt inflation, the key shift is in the way they refer to maximum employment. Rather than setting policy in reaction to “deviations” from maximum employment (as in a typical Taylor Rule), the new Statement focuses on “shortfalls” from maximum employment. The point—again reflected in the opening quote from Chairman Powell—is that the link between a low unemployment rate and rising inflation is no longer as strong as it once was. In our view, this change simply makes explicit what is already Fed practice. Recall that in 2019, the Fed lowered interest rates by 75 basis points even as the unemployment rate sank to 3.5%, a 50-year low.
In part, this strategic shift away from pre-empting what might be incipient increases in inflation acknowledges the persistently inaccurate forecasts of rising inflation—both by official and private forecasters. While the Fed surely will continue to forecast inflation, the new wording implies that policymakers no longer place as much weight on such forecasts.
Importantly, since meeting the Fed’s average inflation target will become more of a backward-looking exercise, there are pitfalls that accompany this broader policy discretion. In particular, it raises worries that the FOMC could repeat the painful errors of the 1970s, when it allowed a large increase in the trend of inflation. While we understand the concern, our view is that policymakers today are far more aware of the importance of anchoring inflation expectations than they were 50 years ago. That awareness, together with some timely clarity from the FOMC about how they will respond to emerging inflation risks, should be enough to ensure matters do not get out of hand.
To sum up, consistent with the relatively relaxed response in financial markets, we view the new Statement as a modest revision to Fed practices. Given the expectation of a long period of zero interest rates, the new Fed strategy responds to the shift in the risks of having inflation fall too low or rise too far.
That said, the market reaction may also reflect a deep skepticism about the Fed’s ability to raise inflation at all, especially in such a deep recession. Having consistently fallen short of the 2% inflation target since it was announced, why should anyone believe that they can boost inflation above 2% anytime soon? Indeed, what makes the Fed different from the other leading central banks of the world that spent the better part of the last decade trying and failing to raise inflation to their target?
Clearly, the proof will be in the pudding. So, how will we discern the impact of the FAIT strategy on Fed decisions? Even without the shift to FAIT, it would probably have been a long time before any hint of policy tightening.
As a result, the most observable difference near term will be in the Fed’s communication—what it says about their policy. As former Chairman Bernanke used to say, “monetary policy is 98 percent talk and 2 percent action.” That is all the more so when, like now, the policy rate is stuck near zero. The more the FOMC can tell us about how they will systematically use the broader discretion in their new framework, the more likely that it will prove effective.