Monetary policy overhauls are usually falsified in times of crisis. Therefore, it is appropriate that, although the Federal Reserve began a major review of its policy framework in 2019, it has only completed this reassessment now amid the worst economic crisis since the Depression. Fed chairman Jerome Powell spoke about changes to the central bank’s framework to an audience of economists and central bankers on Thursday at an annual conference online from the pandemic (usually in Jackson Hole, Wyoming). He stressed that the central bank’s current inflation target of 2% should be an average going forward: Given the persistently low inflation, the Fed could make efforts to bring inflation above the target.
And perhaps most importantly, Mr. Powell stated that the Fed would no longer try to prevent employment from rising above its best estimate of maximum sustainable levels. Recent experiences have convinced the central bank that even very low unemployment rates need not lead to accelerated price increases.
These changes in Fed policy could prove to be the most momentous monetary policy adjustment since the early 1980s, when the Fed’s recession-inducing campaign against double-digit inflation set the stage for the dormant price hikes and lows of recent decades. Despite all of this, the new monetary guidelines are disappointing incremental rather than transformative.
The Fed initiated its strategic review in response to criticism of its performance during and after the 2007-09 global financial crisis. Like most central banks in the rich world, the Fed is guided by an inflation target. When inflation threatens to rise above 2%, the central bank usually adjusts policy (e.g. by raising interest rates) to slow economic growth and prevent price hikes from accelerating further. On the other hand, inflation that is too low generally leads to measures to stimulate economic growth. This system seemed to do well in the 1990s, when America was growing rapidly alongside low and stable inflation.
Since then, however, its shortcomings have become apparent. In a world of falling real interest rates (ie adjusted for inflation), a background inflation rate of 2% is too low to prevent nominal interest rates from repeatedly falling to zero. From this point onwards, central banks can no longer rely on their preferred stimulant political instrument, a rate cut. And too often a focus on preventing inflation from rising above target has led central banks to curb economic expansion before the economy is clearly at capacity. The overall effect has been to unnecessarily depress employment and wage growth.
Economists and central bankers have debated a lot over the past decade about how best to address these shortcomings. Some argued that monetary policy should focus on the price level rather than the rate of increase: if inflation has been too low for a while, this period must be followed by an adjustment of the above-average inflation in order for prices to rise again. Others suggested that one inflation target should be traded for one for money wages or GDP. In the anti-inflation era, prices seemed to be less and less responsive to changes in employment and output, giving monetary policy a bias against dramatic action.
The “natural unemployment rate,” above which price increases inevitably accelerate, has been part of the intellectual basis of monetary policy for almost half a century. Although the Fed’s legal mandate since 1977 has included both maximum employment and stable prices, in practice policy has focused on maintaining low inflation as the surest route to sustainable growth. The new adjustments hold the potential for a fundamental change in monetary policy.
Mr Powell’s revisions will undoubtedly restore full employment as an equal part of the central bank’s “dual mandate”. The Fed has given itself permission to resist the urge to tighten monetary policy when inflation is close to 2% and employment growth is robust (a temptation Mr. Powell did not resist in 2018 when the Fed raised rates despite the evidence repeated increases for the economy fell well short of full employment). Neither Ben Bernanke nor Janet Yellen, the two predecessors of Mr Powell, have managed to make such a profound change during their tenure, although the inadequacy of the status quo has become increasingly evident.
However, the Fed has not committed itself to a more aggressive reflationary policy framework. The new strategy will give the central bank room to accept inflation above target. However, it will not be necessary to take such a path to full employment. It’s also not clear that a target of 2% average will significantly shorten the time the economy spends on interest rates that remain swooned near zero. In a zero-interest world, this policy overhaul could be little more than a promise not to counter the government’s efforts to stimulate growth through fiscal stimulus.
In the end, Mr. Powell’s review revealed a welcome change in response to past failures and legitimate criticism: a rare accomplishment for an American institution these days. However, given the dire outlook for the American economy and the small risk of a more radical overhaul, this seems like a missed opportunity.