Fed unveils historic shift to boost inflation
Powell says low interest rates will spur job growth
The Federal Reserve on Thursday adopted a historic shift in its approach to interest-rate policy that places more emphasis on boosting employment and allows inflation to rise above the Fed’s 2% target during economic expansions, keeping rates lower for longer.
In the current COVID-19-induced economic downturn, the new, longawaited policy likely would keep rates near zero for several more years, economists have said.
“Forty years ago, the biggest problem our economy faced was high and rising inflation,” Fed Chair Jerome Powell said in a speech he delivered Thursday morning to kick off the Fed’s annual conference in Jackson Hole, Wyoming. The symposium is being conducted virtually this year because of the pandemic.
Now, however, Fed officials have become convinced that “a robust job market can be sustained without causing an outbreak of inflation,” Powell said.
Wall Street cheered the Fed’s signal that rates will stay lower longer, a stance that should drive more investments from bonds to stocks. The Dow Jones industrial average was up more than 200 points in midday trading.
The sweeping changes to the Fed’s “monetary policy framework” are rooted in an economy that has been growing more slowly in recent years and inflation that has remained stubbornly below the Fed’s 2% target despite an unemployment rate that fell to a 50-year low of 3.5% before the pandemic.
Under the new policy, the Fed would target inflation that averages 2% over time.
As a result, if inflation undershoots the Fed’s target, as it has for most of the past decade, the Fed would allow inflation to run “moderately above 2% for some time,” Powell said.
That’s significant because persistently low inflation leads consumers and businesses to expect it to continue, perpetuating a cycle of meager price increases.
If workers, for example, expect prices to remain stable, they’re less likely to seek solid wage increases. Low inflation can lead to deflation, or falling prices, that may prompt consumers to put off purchases, hurting the economy.
Also, Powell said, paltry inflation typically prompts very low interest rates, giving the Fed less room to cut rates if the economy turns south.
“Many find it counterintuitive that the Fed would want to push up inflation,” Powell said. “However, inflation that is persistently too low can pose serious risks to the economy.”
The Fed’s framework also now says that its goal of maximum employment will be informed by “shortfalls of employment” from that level, rather than the previous “deviations from its maximum level.” The change underscores Fed policymakers’ view that they can keep rates low to stoke job growth without igniting excessive inflation.
The practical effect is that the “Fed won’t preemptively raise interest rates as the unemployment rate falls unless that is accompanied by actual signs of inflation,” Paul Ashworth, chief U.S. economist of Capital Economics, wrote in a note to clients. Before, the Fed took a more balanced approach that would have led to rate hikes as unemployment fell to very low levels in a bid to head off a potential inflation surge.
That marks a fundamental shift in how the Fed has viewed rate policy for decades. In the early 1980s, amid double-digit inflation, Fed Chair Paul Volcker spearheaded aggressive rate increases, ushering in an era of stable inflation.
The updated policy also acknowledges that the Fed’s key interest rate is likely to hover near zero more frequently than in the past.
“By reducing our scope to support the economy by cutting interest rates, the lower bound increases downward risks to employment and inflation,” Powell said. “To counter these risks, we are prepared to use our full range of tools to support the economy.”
That could mean lowering long-term interest rates by buying Treasury and mortgage bonds, as the Fed is currently doing. Also, by conveying that shortterm rates will stay lower longer, the new policy itself can spur more borrowing and economic activity.
The central bank, in fact, is expected to follow Thursday’s announcement with a vow this fall to keep rates near zero until the economy returns to full employment and inflation reaches 2% over the long term, paving the way for above 2% yearly price increases for a period. Such a promise likely would keep the Fed’s key rate near zero until about 2025, Goldman Sachs has said.
After keeping rates near zero for years amid a sluggish recovery from the Great Recession of 2007-09, the Fed began raising its key rate several years ago as the expansion gained momentum, but then slashed it to near zero again in March as the COVID-19 crisis shut down many U.S. businesses.
The Fed announced its revised monetary policy framework after an 18month review and nationwide events with employee groups, unions, small business owners, and residents of low and moderate income communities, among other constituencies.
Powell said the Fed’s review was spurred by four key developments in the economy in recent years:
● Slower economic growth. Since 2012, Fed officials’ median estimate of the economy’s potential annual growth has fallen to 1.8% from 2.5%.
● Lower interest rates. The Fed’s “neutral federal funds rate” – consistent with a strong economy and stable inflation – has fallen from 4.25% to 2.5%.
● A robust labor market before the pandemic. The record 101⁄2 year old expansion that was abruptly halted by the pandemic “led to the best labor market we had seen in some time,” Powell said.
● Stubbornly low inflation. Among the forces holding down inflation are discounted online shopping and a more globally connected economy.