Insights from the Fed's revised strategy
Updated: Oct 10, 2020
By Conor O'Reilly, Editor of 'This Month in Macro' for the UCD Student Managed Fund
Almost two years after it was first announced, the much-anticipated outcomes of the Federal Reserve’s strategic review were finally revealed during the annual Jackson Hole monetary policy symposium that took place in late August. Over the course of these two years, the Fed has seen inflation fall away from its 2% target, interest rate normalisation has been aborted, and U.S. employment has hit record highs before being decimated by the Covid-19 pandemic. While these factors have certainly influenced the formulation of the new monetary policy framework, it is more about evolution than revolution for the Fed.
Probably the most eye-catching element of the overhauled framework is the new commitment to average-inflation targeting. The clear aim here is to more strongly anchor inflation expectations at the 2% level, as monetary policy will be expected to respond more aggressively to deviations from the target in an attempt to “make-up” for past misses. Indeed, market-based inflation expectations did jump to their highest point year-to-date on foot of the announcement.
For the average-inflation targeting framework to have its best chance of keeping inflation expectations well-anchored at 2% (or at least for there to be a noticeable difference from ordinary inflation-targeting), the commitment to it should be as clear and as credible as possible. Interestingly though, by being vague on details and retaining a large degree of flexibility in how average inflation targeting will be conducted, the Fed has chosen to sacrifice a certain amount of transparency and credibility. Neither the time horizon over which an average measure of inflation will be taken nor the rate at which monetary policy will seek to make-up for past deviations were specified. This reluctance to adopt a clearly-defined, rules-based policy indicates that the Fed is wary of finding itself in a potential “Sophie’s Choice” type scenario whereby it may have to either follow its self-imposed reaction function leading to a potentially undesirable economic outcome, or renege on its reaction function but lose credibility in the process. As stated by Fed Chair Powell (2020):
“Our decisions about appropriate monetary policy…will not be dictated by any formula. Of course, if excessive inflationary pressures were to build…we would not hesitate to act.”
The flipside of this is that by making policy choices largely discretionary, successfully communicating the Fed’s intentions with the public may become more difficult. Furthermore, as highlighted by Mercatus Centre economist David Beckworth (2020), communication with the public will be hugely important under an average-inflation targeting regime. The goal of this regime-change is to explicitly allow overshooting of the inflation target, producing higher inflation and thus higher nominal income and spending. However, without effective communication, higher inflation may easily be perceived as a tax on the wealth of a recession-battered public.
The second big (and perhaps more significant) outcome of the Fed’s strategic review is the new perspective the Fed has on full employment. Rather than reacting to “deviations” from maximum employment, the Fed will now assess “shortfalls” in employment. In other words, employment will be allowed to surpass its perceived maximum (or natural rate) without any monetary policy tightening, so long as high employment is not accompanied by excessive inflation. As detailed by Adam Posen (2020) of the PIIE, this policy pivot reflects a flattening of the Phillips Curve (inverse relationship between unemployment and inflation), a lower rate of economic growth, sticky inflation expectations, and rising labour force participation. It can also be interpreted as an acknowledgement of how the Fed may have acted differently at times over the last decade, given the benefit of hindsight. For instance, the pre-emptive rate hikes of 2017 and 2018, in anticipation of future inflationary pressures due to a tight labour market, may have been enacted more cautiously in retrospect. Moreover, it signals the latest shift in policy becoming less reliant on difficult to measure theoretical constructs such as the “natural rates” of employment and interest, with more attention instead given to directly observable empirical results.
Ultimately, the tweaks to the Fed’s monetary policy framework are relatively minor. More radical changes that have been touted over the last two years, such as the adoption of a higher inflation target or a switch to a nominal GDP level target, have been overlooked for now. Perhaps, this is unsurprising given that monetary policy has arguably performed reasonably well since the Financial Crisis. Although much has been made of consistent undershooting of the inflation target over this period (PCE inflation has averaged 1.5% since 2012), prices remained relatively stable, employment was bolstered, and the monetary policy toolbox was expanded to deal with problems arising at the Effective Lower Bound. The lack of dramatic changes to Fed policy implies a “if it ain’t broke don’t fix it” perspective. Rather than being an inflection point, this is just the latest evolution of Fed policy, with a high level of trust retained in the kernel of the existing framework.
This article was first published in the UCD Student Managed Fund's 'This Month in Macro' magazine in early October 2020.
Beckworth, David (2020) “A New Way to Manage Inflation”, Mercatus Centre, 27 August 2020
Posen, Adam (2020) “What Fed Chair Jerome Powell did and did not say”, Peterson Institute for International Economics, 27 August 2020
Powell, Jerome (2020) “New Economic Challenges and the Fed’s Monetary Policy Review”, Federal Reserve, 27 August 2020
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