The United States Federal Reserve – steward of the US and global economies – announced on Thursday a truly historic shift in how it will craft monetary policy. And it is profoundly consequential to everyone in the US and beyond.
Put wonkily, the Fed is willing to let inflation run higher than it was willing to tolerate previously, which could make ultra-low interest rates a feature for years to come. It also adjusted its view of maximum employment to focus on “shortfalls” rather than “deviations”.
In plain English, the nation’s central bankers are not going to freak out and hike interest rates over fears that a robust rebound in the pandemic-ravaged US jobs market could cause prices to soar out of control.
The new policy framework, unveiled by Fed Chairman Jerome Powell during a virtual speech for the annual gathering of central bankers usually held in Jackson Hole, Wyoming, signals the Fed is not going to get in the way of getting Americans back to work by hiking borrowing costs unnecessarily.
Instead, the Fed going to place fears of creeping prices firmly on the back burner as the labour market tries to recover from COVID-19 disruptions that have seen initial claims for state unemployment benefits top one million every week but one since mid-March.
“This change reflects our appreciation for the benefits of a strong labour market, particularly for many in low- and moderate-income communities,” said Powell.
This change reflects our appreciation for the benefits of a strong labour market, particularly for many in low- and moderate-income communities.
Inflation used to be the big problem
Prioritising jobs creation over fears of spiking inflation might seem like the obvious thing to do right now. But to understand why this shift in the Fed’s policy framework is truly epic, wind back the clock to 1980, when the US economy was being ransacked by an inflation rate that hit 14 percent.
The Fed has a dual mandate to implement monetary policy that achieves both maximum employment and stable prices.
When prices spike, consumers are worse off because they can’t purchase as much. And that hurts everyone because consumer spending drives some two-thirds of US economic growth.
Forty years ago, when the late Paul Volcker was Fed chief, his main priority was to tame blistering inflation and restore price stability, even if it meant temporarily enduring higher unemployment rates.
In 1980, under Volcker, the Fed raised its benchmark interest rate to 20 percent.
Eventually, Volker and his successor, former Fed chief Alan Greenspan, succeeded in reining in inflation and crucially, inflation expectations, to around two percent.
Under Ben Bernanke, who took over as Fed chief in 2006 and captained the US central bank during the dark days of the financial crisis and the Great Recession, the Fed explicitly set its long-run inflation target at two percent.
That was 2012.
Since then, as Powell explained on Thursday, the Fed’s “understanding of the economy has evolved in ways that are central to monetary policy”.
A new understanding, informed by real people
Key to the Fed’s enhanced understanding of the economy is what was happening in the roughly two years preceding the coronavirus lockdowns that swept the nation in March.
Before lockdowns tipped the US economy into its sharpest quarterly contraction on record and devastated the labour market, employment was hovering at near 50-year lows. The number of people either with a job or actively looking for one – the so-called “labour force participation rate” – was also rising.
Moreover, as Powell noted on Thursday, the gains from the longest economic expansion in the nation’s history “began to be shared more widely across society”.
The unemployment rates for African Americans and Latinos were at record lows, while the gaps between those rates and the white unemployment rate narrowed to their lowest levels as well.
The Fed’s evolving view wasn’t only driven by statistics. Through its “Fed Listens” events, it asked all sorts of people – from union members to small business owners, from residents of low- and moderate-income neighborhoods to retirees – how monetary policy was affecting their everyday lives.
“As we heard repeatedly in our Fed Listens events, the robust job market was delivering life-changing gains for many individuals, families, and communities, particularly at the lower end of the income spectrum,” said Powell.
The robust job market was delivering life-changing gains for many individuals, families, and communities, particularly at the lower end of the income spectrum.
Though the labour market was on fire in the two years leading up to the pandemic, inflation was falling well short of the Fed’s longer-run, two-percent target. That, in turn, fed into general interest rates, Powell noted.
This creates problems because it means the Fed effectively loses wiggle room to cut interest rates if it needs to give the jobs market a shot in the arm during a downturn, possibly resulting in sharper, longer contractions.
“We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome,” said Powell. “We want to do what we can to prevent such a dynamic from happening here.”
President Donald Trump heavily criticised Powell and the Fed for raising interest rates four times in 2018 to a post-Great Recession peak of 2.5 percent.
The Fed slashed interest rates to near zero this year once the pandemic struck and unleashed a host of unconventional tools to try and help the economy through the tumultuous upheaval spawned by COVID-19.
But the Fed’s newly declared tolerance for periods of inflation that move above its two-percent target rate in exchange for keeping the labour market going strong is not a knee-jerk reaction to the economy’s pandemic problems.
Rather, it’s an acknowledgment of what the data, and real people have been telling the nation’s monetary policymakers: that a strong labour market doesn’t always mean prices are about to skyrocket.
If inflation does start to get too heady, Powell said the Fed “would not hesitate to act”.
But for now, the Fed’s number one priority is not keeping inflation in check. It’s getting Americans back to work.