Federal Reserve’s New Policy On Inflation Would Keep Interest Rates Lower For Longer Periods

Federal Reserve Chairman Jerome Powell said Thursday that the central bank will shift to a policy of “average inflation targeting.” This means the Fed will now permit the inflation rate to rise “moderately” above its 2% target in order to uphold the labor market before raising interest rates.

Speaking by video in a virtual version of the Jackson Hole Economic Policy Symposium, Powell called the measure a “robust updating” of Fed policy.

As a result, the Fed will be less willing to raise interest rates when the jobless rate declines – as long as inflation remains modest. Historically, the Fed had contended that low unemployment leads to excessive inflation.

“The persistent undershoot of inflation from our 2% longer-run objective is a cause for concern,” Powell said. “Many find it counterintuitive that the Fed would want to push up inflation. After all, low and stable inflation is essential for a well-functioning economy. And we are certainly mindful that higher prices for essential items, such as food, gasoline, and shelter, add to the burdens faced by many families, especially those struggling with lost jobs and incomes.

"However, inflation that is persistently too low can pose serious risks to the economy," he continued. "Inflation that runs below its desired level can lead to an unwelcome fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations.”

In response to Powell’s remarks, Steve H. Hanke, a professor of applied economics at Johns Hopkins University who also served on President Reagan's Council of Economic Advisers, told International Business Times: “Chairman Powell and his Fed colleagues have signaled that they don't see an inflation threat on the horizon and will turn a blind eye toward that metric.”

Hanke added: “But, if the Fed continues to keep the pedal on the money supply metal, it's tune will change when inflation hits 3.5%-4%.”

Powell also said that with interest rates “generally running closer to their effective lower bound even in good times, the Fed has less scope to support the economy during an economic downturn by simply cutting the federal funds rate,”

As a result, that can lead to “worse economic outcomes in terms of both employment and price stability, with the costs of such outcomes likely falling hardest on those least able to bear them.”

Greg McBride, chief financial analyst at Bankrate, commented that from an interest rate standpoint, the Fed will now likely keep interest rates “lower for longer, and lower more often.”

“While 2% is still the right number when it comes to inflation, the Fed is massaging their definition of [the] inflation target to an average of 2% inflation over time,” McBride said. “But even their definition of ‘average’ is squishy, as it won’t be a formula but a broader assessment of the impact of inflation on the economy.”

The Fed, McBride added, is “leaning toward a little more art than science” when it comes to determining when it is time to raise rates and curtail inflation.

The Fed reiterated that it will not hesitate to act if inflation pressures build, but McBride cautioned that just how soon that might be tested remains to be seen.

“Inflation that persistently undershoots 2% is what has motivated these adjustments now,” he said. “[But] inflation is kryptonite to bond investors and the Fed’s willingness to tolerate higher inflation from time to time will result in periods where longer-term bonds are prone to big price declines. With low inflation the Fed’s focus now, that’s a concern for another day – but a concern nonetheless.”

Powell’s speech also noted the Fed will slightly change its view of employment, by looking at “assessments of the shortfalls of employment from its maximum level.”

“Our revised statement emphasizes that maximum employment is a broad-based and inclusive goal,” Powell explained. “This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.”

McBride said the new employment policy acknowledged how “economic prosperity has often failed to reach all segments of society and being cognizant of that when setting policy in the future.”

Powell further said the central bank will not establish a specific goal for the jobless rate, but instead will permit economic conditions to determine what it regards as “full employment.”

He concluded: “We will remain highly focused on fostering as strong a labor market as possible for the benefit of all Americans. And we will steadfastly seek to achieve a 2% inflation rate over time.”

C.J. MacDonald, client portfolio manager at GuideStone Capital Management in Dallas, told IB Times, that “it is far easier to enact a goal of increasing inflation than it is to achieve it.”

Powell, MacDonald said, wants the economy and investors to reframe their future expectations for inflation.

“Powell clearly feels that the only way we will see an average level of 2% inflation is if it is allowed to run higher than that for a long time,” he stated. “Also, a big change in Fed policy also outlined today is that the Fed does not fear a very low unemployment rate anymore. They previously set a floor for the lowest unemployment rate for a healthy economy. However, due to long-term changes in the employment market, they will let the rate fall as low as possible. They will only seek to affect the labor market if unemployment rises.”