On Thursday, August 27, Jerome Powell announced that the Federal Reserve is changing policy on two counts. First, the Federal Open Market Committee (FOMC) will now target the average rate of inflation. Second, the FOMC will no longer attempt to minimize deviations of observed employment levels from the maximum sustainable level of unemployment but will instead only attempt to address “shortfalls of employment from its maximum level.” In other words, the FOMC will only tighten in response to increases in inflation and will ignore rising levels of employment as a proxy for inflation. It will, within bounds, ease policy in response to increasing unemployment.
In short, the FOMC will allow for inflation to rise above the 2% level for limited periods of time and, consequently, allow nominal interest rates to rise with inflation.
Over the last several months, Powell has continually reassured investors that the Federal Reserve would maintain an easy policy for the foreseeable future. He has made these reassurances as the FOMC has held public hearings on monetary policy. Thus, investors had reason to expect that the average rate of inflation would move higher in the near future.
Many in the press were anticipating this outcome, as were investors. The yield curve, which was essentially flattened in February, briefly stretched in May and June. As of August 27, 30-year Treasuries reached short-term highs, likely indicating increased confidence in expected inflation and renewed confidence in economic growth that had briefly cooled with the renewal of lockdowns.
The Previous Regime of Inflation Targeting
For more than a decade, Federal Reserve policy has reflected a fear of inflation. Paul Volcker and Alan Greenspan established a norm of leaning against the wind. When inflation expectations rose, they would increase interest rate targets, thus indicating a policy of monetary tightening. When inflation expectations fell, they would lower interest rates. This policy structure succeeded in greatly reducing the level of expected inflation, especially expectations of inflation over longer time horizons.
Departing from the norm set by Alan Greenspan, Ben Bernanke expressed concern that inflation expectations were not perfectly anchored. While long-run inflation expectations were well anchored, Bernanke preferred to limit short-run variability in inflation expectations. He believed that this variability could lower the level of output as investors and producers take costly action to avoid even higher costs incurred due to short-run fluctuations in the value of currency.
In a speech in July 2007, shortly before the first phase of the approaching financial crisis, Bernanke noted that “If the public reacts to a short period of higher-than-expected inflation by marking up their long-run expectation considerably, then expectations are poorly anchored.” If short-run expectations are not well anchored, this could lead to more variable and higher long-run inflation expectations. Bernanke was unwilling to let inflation expectations rise much above 2.5%. And over much of the last decade, and especially in the last 5 years, observed inflation and inflation expectations have tended, on average, to be below its already low 2% inflation target. The Fed has muted the inflationary effects of monetary expansion by paying interest on excess reserves. Lower inflation expectations reflect that investors have accounted for the effects of this strategy.
Source: FRED Economic Data
However, in a piece for the Brookings Institute, Bernanke observed that one benefit of a higher inflation target is that it leaves more flexibility for the central bank to lower interest rates during a downturn. (He also argued that negative nominal interest rates could accomplish this.)
Powell’s recent announcement that the FOMC will target an average inflation rate will ensure that the Federal Reserve does not persistently undershoot its target as it has for much of the last decade. The Fed has softened this emphasis on stabilization of short-run inflation expectations.
With the expectation that inflation will tend to be higher, the growth rate of nominal income (i.e., the price level multiplied by real output) will tend to increase. As the economic activity recovers, this will encourage more borrowing and lift interest rates. If the economy moves from boom to bust, the Federal Reserve will have more room to provide support to financial markets since interest rates will tend to be higher under a regime with a higher average rate of inflation.
Powell’s new program is consistent with recent changes in monetary policy during the Covid-19 crisis. Over the last few months, the Federal Reserve has provided immense support to financial markets when it was clear an economic downturn was imminent. The federal funds target moved nearly to 0% as it trailed a general fall in the yield curve. Accommodation from the Federal Reserve alongside massive fiscal expansion has put the level of nominal income on the road to recovering to its trend preceding the Covid-19 crisis. The FOMC has also pledged to support financial markets for a longer period after a downturn. Under the old program, the Federal Reserve might use a fall in the level of unemployment below the estimate consistent with full employment as a reason to allow rates to increase. This will no longer be a consideration moving forward. Changes in unemployment can only encourage further easing. It will not directly influence decisions to tighten monetary policy.
The expected result is that a rebound of inflation will be allowed to occur more quickly during periods of recovery and increases in the interest rate target will tend to occur only after the rate of inflation rises above the average trend. There will also be a one-time increase in nominal interest rates, reflecting the new, higher level of inflation, and greater variability in short-term rates, since these are influenced by greater variability in short-term expectations of inflation.
It appears that financial markets may still be processing the expected increase in rates. Rates on 10-year and 30-year Treasuries have increased significantly over the last week. Rates on the shortest maturities have shown some response, but are relatively flat. Eventually short-term rates will also begin to rise in light of this commitment to a higher rate of inflation.
In the short-term, the FOMC will have to balance the inflationary effects of a negative supply shock. If the negative supply shock raises inflation well above 2 percent, the Fed may not be inclined to allow for lower rates of inflation after the shock passes. In the least, it is a tricky time to implement this rule change.
Over the longer term, the new target should also reduce the swiftness with which the yield curve falls during a recession while leaving greater room for policymakers to reduce interest rate targets. Expectations of higher inflation rates should otherwise limit the extent of a downward movement in rates during a recession, especially long-term rates since those are influenced by long-run inflation expectations to a much greater extent.
The bottom line is that the Federal Reserve has increased its commitment to offset a fall in the total level of expenditures in response to an economic downturn. Absent a systematic disruption in the structure of international monetary arrangements or another factor that cannot be offset by monetary policy, the FOMC will ensure that downturns are met with accommodation from monetary policy.