Fed to tolerate higher inflation in policy shift

Fed to tolerate higher inflation in policy shift

The Federal Reserve has adopted a new strategy for monetary policy that will be more tolerant of temporary increases in inflation, cementing expectations that the US central bank will keep interest rates at ultra-low levels for years to come. 

Jay Powell, the Fed chair, announced the shift as he addressed the Jackson Hole monetary policy symposium, which began in virtual format on Thursday.

“Because the economy is always evolving, the FOMC’s strategy for achieving its goals — our policy framework — must adapt to meet the new challenges that arise,” Mr Powell said, according to prepared remarks.

The centrepiece of the Fed’s new approach is the move to an average inflation target, which will allow the measure to overshoot the US central bank’s 2 per cent target to compensate for persistently low inflation, the likes of which has been weighing on the US and other economies in recent years.

“Following periods when inflation has been running below 2 per cent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time,” Mr Powell said. 

The Fed also adjusted its thinking on the labour market and the level of employment that can be maintained without leading to destabilising consumer price increases. The Fed will now base its policy decisions on “assessments of the shortfalls of employment from its maximum level”, rather than “deviations from its maximum level”. 

Mr Powell said the “subtle” change “reflects our view that a robust job market can be sustained without causing an outbreak of inflation”. 

He added that “going forward, employment 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”.

The Fed’s new approach was formalised by an FOMC statement on its longer-run strategy and goals. It could set the stage for the US central bank to issue new, more detailed forward guidance on the necessary conditions for it to raise interest rates from their current level near zero.

The Fed explicitly acknowledged the constraints posed by the current level of interest rates. Mr Powell stressed that “the Fed has less scope to support the economy during an economic downturn by simply cutting the federal funds rate”.

The conclusions of the central bank’s nearly two-year strategy review have been widely anticipated.

In practice, the Fed has already moved away from the inflation-fighting mantra that characterised its policies in previous decades, most notably under the chairmanship of Paul Volcker. But crystallising that change was seen as particularly important after the US was hit by the pandemic. The median forecast of Fed officials does not see an interest rate increase until after 2022 at the earliest. Mr Powell has previously said the Fed was not “thinking about thinking” about tightening policy. 

The Fed also reframed its views on maximum employment, stating that the goal is now a “broad-based and inclusive” one.

“This change reflects our appreciation for the benefits of a strong labour market, particularly for many in low- and moderate-income communities,” Mr Powell said in his speech. He highlighted the gains achieved prior to the coronavirus outbreak, in which black and Hispanic unemployment rates fell to record lows. 

“The robust job market was delivering life-changing gains for many individuals, families, and communities, particularly at the lower end of the income spectrum,” said Mr Powell. “Many who had been left behind for too long were finding jobs, benefiting their families and communities, and increasing the productive capacity of our economy.”

US Treasuries initially rallied after Mr Powell’s remarks were released, before reversing course. After falling to 0.65 per cent, the yield on the benchmark 10-year note rose to 0.7 per cent. Meanwhile, the yield on the 30-year Treasury note climbed to 1.4 per cent, having fallen to 1.36 per cent at one point. Yields rise as prices fall.

Short-dated Treasuries rallied, with the yield on the two-year note falling to 0.14 per cent.