International Forecaster Weekly

Fed Changing Policy on Inflation and Unemployment

...monetary policy still operates under the existing assumption that such a tradeoff - i.e., a strong labor market and stable prices - actually exists.

Guest Writer | August 29, 2020

...Powell Says Goal Is to Keep Interest Rates Lower for Longer.  By Dave Allen for Discount Gold & Silver

Yesterday, Federal Reserve Chair Jerome Powell announced that the Fed will allow inflation to run higher than normal to support the labor market and broader economy. It's a move that Powell calls a "robust updating" of Fed policy by implementing "average inflation targeting."  In other words, the Fed will permit inflation to run "moderately" above the Fed's 2% target for an unspecified period of time after it's run below that objective (such as now and the recent past).

The changes are part of a Fed blueprint called the "Statement on Longer-Run Goals and Monetary Policy Strategy," first adopted in 2012.

That statement provides the framework for how the Fed approaches interest rates and overall economic growth. In reality, the move means the Fed will be less inclined to hike interest rates when the unemployment rate falls, as long as inflation doesn't jump substantially at the same time. 

Most mainstream economists, including Fed officials, traditionally have believedthat prolonged low unemployment leads to dangerously higher levels of inflation, and they've usually moved preemptively to try to head it off.

However, Powell's pronouncement at the Fed's annual Jackson Hole economic policy symposium signaled a shift away from the old thinking. The policymaking Federal Open Market Committee unanimously approved the changes.

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" as well. Powell noted that the interest rate level that neither limits nor pushes growth - known as the "neutral rate" - has fallen considerably over the years and is likely to stay low for the foreseeable future.

Over the past four decade or so, fundamental changes in the economy - such as demographics and technology - have shifted the Fed's focus to inflation that has run undesirably low. And that, Powell said, can lead to a vicious cycle in which longer-term inflation expectations fall, which, in turn, can pull actual inflation even lower..." 

As a result, policymakers are left with too little room to lower rates during times of economic stress. Since the end of the Great Recession, the Fed has struggled to hit its 2% inflation target - hitting or exceeding the target just 15 quarters out of last 102 months through June 2020. 

Officials hope that the new approach will change that landscape, raising expectations and allowing inflation to float higher as interest rates remain low. While Powell did not specify how much higher the Fed would like to see inflation run, Dallas Fed President Robert Kaplan said later in the day that he would be content with a range of 2.25%-2.5%.


In addition to the shift on inflation, the Fed also announced a minor adjustment to how it approaches unemployment. The new language says the approach to jobs will be informed by the Fed's "assessments of the shortfalls of employment from its maximum level." The prior policy referred to "deviations" from the maximum level.

Powell said the tweak is a lot more than a matter of semantics. "This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities," he said.  "This change...reflects our view that a robust job market can be sustained without causing an outbreak of inflation."

More significantly, Powell said the Fed won't set a specific goal for the unemployment rate but rather will allow conditions to dictate what it actually considers full employment. Previous Fed forecasts had expected inflation to rise well ahead of the 3.5% generational low that unemployment had hit before the pandemic, but that didn't happen. As a result, Powell said the Fed remains of the belief that 2% inflation is still the proper target over time.

Julia Coronado, president MacroPolicy Perspectives and a former Fed economist, said that many Americans are bypassed by the market and credit supports that are the Fed's domain. Yesterday, Coronado said that the Fed's arsenal of policy tools is "increasingly not well-suited to the a society characterized by extreme inequality." She added, "Full employment is a truly macroeconomic outcome that...really means we're getting to the people that are the most vulnerable. "They're the ones that suffer the most in a recession" and "the last to realize the benefits of the expansion." 

On the other hand, the Fed has taken unprecedented steps to lessen the pandemic's blow to the economy by flooding financial markets with liquidity and rolling out emergency lending programs for struggling local governments and midsize businesses. 

It's unclear what the long-term effects of those moves will be and even more uncertain when the Fed will be able to rollback or shut them down.  Powell and his Fed colleagues have repeatedly emphasized since early summer that a stable recovery depends on controlling the virus and more aid from Congress.


Joe Wiesenthal argues that skeptics have good reason to wonder what these changes will actually accomplish. For one thing, he notes, higher inflation isn't actually a good thing. For another, the Fed's been missing low its existing 2% inflation goal for a long time, so what's the value in aiming higher? Won't it just miss that too, only by more?

Remember that turning its attention to higher inflation is the Fed's way of aiming for a stronger labor market. The existing approach to monetary policy operates assuming there's some tension between strong job gains and stable prices. And that if things were to get too good for workers, then prices might suddenly spike, requiring the Fed to rate hikes to cool things off. Perhaps in tolerating higher inflation, the Fed is sending a signal that the next time the labor market gets strong, they'll hold off for longer than they otherwise would have, before hiking rates. 

It's not that far out and it might not even result in higher inflation, but if they had had this stance after the last crisis it's possible they wouldn't have raised rates in 2015.

Rachel Siegel says to imagine the Department of Transportation setting the speed limit on a highway. Except, instead of posting a permanent fixed speed limit sign, it publishes a specific number of auto accidents it'll tolerate and a variable rate of how fast cars can go. "A willingness to allow for some higher number of accidents," Siegel says, "is a signal that the cars will be allowed to go faster than they otherwise would have been allowed to go." "The goal isn't more accidents," she adds. "The goal is faster cars, and that's achieved by accepting some modest decrease in safety."

Of course, monetary policy still operates under the existing assumption that such a tradeoff - i.e., a strong labor market and stable prices - actually exists. And a future Fed could still move into panic mode if inflation were to pick up such that a dreaded price spiral could happen, prompting a rate hike anyway.  But at the margin, these policy changes could result in the Fed letting labor markets run stronger for longer. And, for once, that's not a bad thing.