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Fed Reveals New Attitude Toward Inflation in Major Policy Shift

The Federal Reserve signals low rates and a looser inflation targeting strategy.

(Investopedia) Yesterday U.S. Federal Reserve Chief Jerome Powell delivered his Jackson Hole speech and unveiled a refreshed policy framework. As predicted, he announced the central bank would adopt a "flexible" average inflation targeting strategy. The Fed has given itself room to loosen policy (maintain low, but not negative, rates) and allow inflation to rise "moderately" above 2% for periods, as it focuses on increasing broad-based employment.


Historically, central bankers would try to preempt inflation and raise interest rates when full employment was approached, but not any more. "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," said Powell. "However, inflation that is persistently too low can pose serious risks to the economy. 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."


The Fed's new framework is good news for U.S. stock and gold investors and borrowing rates (auto loans, mortgages etc.) will remain low. It's bad news for the dollar. The ECB and other central banks around the world with firm inflation ceilings could also be inspired to do the same.


Challenges


U.S. inflation has remained stubbornly below 2% since 2012, and higher prices is a hard sell to people during a pandemic and the worst economic downturn in decades. Powell's challenge will be explaining why this historic policy shift, which is as significant as that of Paul Volcker's during his battle against runaway high inflation in the 1970s, is necessary.


Volcker's situation highlighted the behavioral aspect of how policies work. He famously allowed unemployment to soar as he cut the supply of money to the economy and faced intense criticism and pressure for a while. Inflation remained high for a long time because people were simply not convinced it would drop and managers continued to increase wages. Another famous example of policy makers failing to control prices is Japan.


Powell will also have to convince markets and investors that the Fed is capable of raising inflation considering how low it stayed even when unemployment was low, defying the Phillips curve. Technological innovations and cheap manufacturing overseas will continue to push prices lower. The Fed will also need a deadlocked Congress' co-operation on fiscal support to make this work. Weekly initial job claims have come in above 1 million 22 times in the last 23 weeks, and fears are rising that the U.S. is now seeing a "K-shaped" recovery with the crisis widening inequality


No Details Yet


Although we now have an idea of this dovish path, worrying experts right now is the lack of details on implementation. "To me this is not a formula, it's not a commitment, we're not going to use arithmetic average," said Dallas Fed President Robert Kaplan to CNBC. "What does 'moderate' mean to me? Probably 2 and a quarter, 2 and a half."


"We do not know how much inflation the Fed is willing to tolerate and for how long. We do not know under what conditions they are willing to ease policy further. We do not know how long they will tolerate the long end of the yield curve drifting higher. In short, we are still waiting for operational guidance to support the new policy," wrote economist Tim Duy in a blog post.

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