August 27, 2020
  • The Fed now views the main threat to an economic expansion as a lack of financial stability rather than secondary considerations such as inflation or maximum employment.
  • It frees the Fed from having to reconcile its policy stance with nebulous concepts including the Phillips Curve and the natural rate of unemployment.
  • This shift will have practically no impact in the near term, but could have profound consequences for the US economy in the years to come.

What Happened

At the Federal Reserve’s (Fed) annual economic policy symposium in Jackson Hole, Chair Jay Powell unveiled an update to the monetary policy framework following a formal review that began in November 2018. It marks a dramatic, though long-expected, shift in the Fed’s approach to monetary policy. The two biggest changes involve inflation targeting and maximum employment.

The Fed will now attempt to achieve its longer-run inflation goal of 2% over time. In other words, following periods when inflation has been running below 2%, the Fed will allow inflation moderately above 2% for some time.

With respect to maximum employment, the Fed will take a more nuanced approach. In today’s speech, Powell noted that [paraphrasing] targeting a specific employment goal is unwise because the maximum level of employment is not directly measurable and changes over time for reasons unrelated to monetary policy. Broader employment measures—including the labor force participation rate—will continue to inform monetary policy.

Our Take

For decades, the Fed has wrestled with communicating its strategy for monetary policy, especially with regards to inflation. The Fed’s so-called dual mandate of maximum employment and price stability (aka inflation watch) has long been seen as untenable and, not surprisingly, is not required of any other central bank. All other central banks have a singular focus of price stability.

In reality, the shift to inflation targeting simply formalizes what the Fed has informally espoused for better than a decade. Former Fed Chair Ben Bernanke has been researching symmetrical inflation goals since the late 1990s and first floated a possible shift to inflation targeting as early as 2003. More recently, Fed leadership—nearly unanimously from board governors to regional presidents—has repeatedly mentioned inflation symmetry when discussing inflation publically.

Similarly, the Fed’s thought leaders have long been downplaying the ability of monetary policy to achieve maximum employment. Powell quite literally echoed their points that the level of maximum employment is a moving target, is subject to considerable lags and changes over time for reasons unrelated to monetary policy.

By extension, the Fed has jettisoned the Phillips Curve, a long-held economic theory that states that higher levels of employment (i.e. a lower unemployment rate) will eventually stoke inflation. To be sure, the Phillips Curve orthodoxy always had detractors. As far back as the 1960s, Nobel laureates Milton Friedman and Edmund Phelps asserted that the Phillips curve was only relevant in the very short term. It also lifts the yoke of the natural rate of unemployment, the constantly-moving target technically known as the Non-Accelerating Inflation Rate of Unemployment (NAIRU). It is the theoretical unemployment level below which instigates inflation.

Both the Phillips Curve and NAIRU required painful Fed contortion when attempting to communicate its strategy. For instance, there was a seemingly constant drumbeat from some corners over the past few years that the Fed was somehow negligent for maintaining low interest rates while the unemployment rate was under 5% from mid-2016 through early 2020.

More importantly, the unemployment rate does not capture aspects such as demographic shifts and productivity. Nor does it accurately reflect the lower end of the income spectrum, which is largely minority groups.

The reality, which the Fed acknowledged today, is that employment and inflation are rarely in sync. Hence, the Fed has stopped chasing the ghost of maximum employment.

Bottom Line

The Fed has functionally shifted to a single mandate, with all other objectives becoming secondary to reaching the symmetrical objective. With the benchmark policy rate at the zero lower bound, this shift will have practically no impact in the near term. The Fed has already signaled—and the market expects—it would keep rates low for several years. Or, as Powell recently said, “we’re not even thinking about thinking about raising rates.”

More importantly, it means that the Fed views the main threat to an economic expansion as a lack of financial stability rather than secondary considerations such as inflation. This shift in the Fed’s thinking could have profound consequences for the US economy in the years to come. It preps markets that, going forward, the Fed will allow inflation to move above the 2% objective, letting the economy run a little hotter. No longer should markets view the 2% inflation goal as a ceiling.

This indirectly speaks to the greater sensitivity of the economy to markets, asset values and liquidity. In turn, the Fed has increasingly become more cognizant of market activity. Case in point, several of the Fed’s boldest moves during the Great Financial Crisis targeted continued market function rather than economic growth and certainly had little regard for inflation. Most recently, nearly all of the Fed’s responses to the pandemic were aimed at improving liquidity and market function. Ultimately, the Fed is signaling that it must be more attentive to financial stability and bouts of market dislocations rather than inflation.

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