Central bankers look to change long-running strategy to encourage lower rates, shift unemployment-inflation dynamic
By Nick Timiraos Aug. 2, 2020 5:30 am ET
The Federal Reserve is preparing to effectively abandon its strategy of pre-emptively lifting interest rates to head off higher inflation, a practice it has followed for more than three decades.
Instead, Fed officials would take a more relaxed view by allowing for periods in which inflation would run slightly above the central bank’s 2% target, to make up for past episodes in which inflation ran below the target.
“It would be a significant change in terms of how they are thinking about” the trade-off between employment and inflation, said Jan Hatzius of Goldman Sachs. “A lot of those things look very different now from the way they looked a few years ago,” he said.
Fed Chairman Jerome Powell hinted at the shift at a news conference last week when he said the central bank would soon conclude a comprehensive review of its policy-making strategy that began last year.
Mr. Powell initiated the review with an eye toward beefing up the Fed’s ability to counteract downturns in a world where interest rates are lower and more likely to remain pinned at zero.
Even before the severe shock from the coronavirus pandemic, the Fed had grown concerned about spells of low inflation that have bedeviled authorities in Japan over the past two decades and in Europe for the past decade.
The change being contemplated now is a way of essentially telling markets that rates will stay low for a very long time. Markets have likely already picked up on this change, given the continued declines in long-term interest rates.
The changes on their own will do little to provide more support to the economy right now because investors already understand that the Fed isn’t likely to raise interest rates for years, said Steven Blitz, chief U.S. economist at research firm TS Lombard. “It is a change at this point without meaning. It’s just words,” he said.
The Fed would formally adopt changes by altering a statement of long-run goals that it approves annually, something it last did in January 2019. “The changes we’ll make…are really codifying the way we’re already acting with our policies,” Mr. Powell said last week.
One way for the Fed to do that would be to amend that document to say inflation should average 2% “over time.”
The virus shock led the Fed in March to rapidly slash short-term rates to zero, purchase trillions of dollars in government-backed debt and deploy an array of programs to backstop lending markets.
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Because of the pandemic, Mr. Powell tabled discussions this spring over the framework review. The Fed resumed those discussions at their two- day meeting last week and could seek to conclude them as soon as their Sept. 15-16 meeting.
The Fed formally adopted the 2% inflation goal, a level it regards as consistent with healthy economic growth, in 2012. At the time, short-term rates also were pinned near zero. But central bankers, economists and investors still expected those rates to return to more normal levels of 4% or so once the economic expansion matured.
Even before the pandemic hit, those rates were stuck at much lower levels than 4% for reasons that weren’t expected to change soon, such as demographics, globalization, technology and other forces that have held down inflation.
The Fed justified pre-emptive rate increases because monetary policy works with a lag. “Now, you’re saying, ‘Yes, there may be lags behind, but we’re OK with an inflation overshoot because inflation has run so much below,’” said Priya Misra, an interest-rate strategist at TD Securities.
The Fed says its current 2% inflation target is symmetric, meaning officials are as uncomfortable with inflation somewhat below as somewhat above that level. In other words, 2% isn’t a ceiling. In addition, the Fed under this approach is always aiming for 2%, and it doesn’t take into account previous deviations.
The problem for some officials is that the results haven’t been symmetric; inflation has run at or under the target, but never above it.
The Fed’s misses on inflation over the past five years were relatively small. But some officials were concerned because if the Fed can’t meet its target after a long time, consumers and businesses could expect even lower inflation. Such expectations can become self-fulfilling, and officials would be alarmed if they were falling because of the important role expectations play in determining actual prices.
In speeches over the past year, Fed governor Lael Brainard has called for shedding the current approach and taking up a way to make up for past misses of the target.
Last month, Ms. Brainard approvingly cited research that would have the Fed refrain from raising rates until inflation reached 2%, rather than initiating rate increases before achieving the target and on the basis of a forecast of higher inflation, as the Fed did in 2015.
Other Fed officials have signaled more comfort with overshooting the inflation target in recent weeks. In an interview last month, Philadelphia Fed President Patrick Harker said he would prefer to hold rates at low levels “until we see substantial movement in inflation to our 2% target” with inflation “ideally overshooting a bit.”
Any changes the Fed makes would coincide with a deeper emphasis on the benefits of very low levels of unemployment. For years, officials were concerned that allowing unemployment to fall too low could generate undesirable levels of inflation, which occurred after the 1960s.
In the most recent expansion, however, officials were surprised to find unemployment falling to levels associated with higher prices, but without the anticipated inflation.
By raising rates based on a forecast of higher inflation, the Fed risks short-circuiting a labor- market expansion when many of the most disadvantaged workers are finally getting jobs or raises. That can be costly if inflation doesn’t materialize, said Atlanta Fed President Raphael Bostic on Twitter last month.
“This isn’t inflation for inflation’s sake,” said Mr. Bostic.
The changes under consideration “would be very meaningful because it would be memorializing their commitment to working toward a tighter labor market when the economic circumstances allow for it,” said Rep. Denny Heck (D., Wash.), who is on the House Financial Services Committee. “It would be a huge break from the past.”
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