The Fed makes its biggest inflation-policy change in decades

MONETARY-POLICY OVERHAULS tend to be forged in times of crisis. So it is fitting that, though the Federal Reserve began a grand review of its policy framework in 2019, the conclusion of that reassessment has emerged only now, in the midst of the worst economic crisis since the Depression. Addressing an audience of economists and central bankers on Thursday at an annual conference (usually at Jackson Hole, Wyoming) moved online by the pandemic, Jerome Powell, the Fed’s chairman, announced changes to the central bank’s framework. He emphasised that the central bank’s existing target for inflation, of 2%, should henceforth be an average: in the face of persistently low inflation, the Fed may pursue efforts to push inflation above the target.

And perhaps most important, Mr Powell noted that the Fed would no longer attempt to prevent employment from rising above its best estimate of the maximum sustainable level. Recent experience, he suggested, had persuaded the central bank that even very low levels of unemployment need not translate into accelerating price increases.

These changes to Fed strategy may well prove the most consequential adjustment to the conduct of monetary policy since the early 1980s, when the Fed’s recession-inducing campaign against double-digit inflation set the stage for the quiescent price rises and rock-bottom interest rates of the past few decades. Yet, for all this, the new monetary guidelines are disappointingly incremental, rather than transformative.

The Fed initiated its strategic review in response to criticism of its performance during and after the global financial crisis of 2007-09. Like most rich-world central banks, the Fed orients its policy around an inflation-rate target. When inflation threatens to rise above 2%, the central bank typically adjusts policy (by raising interest rates, for example) to slow economic growth and prevent a further acceleration in price rises. Inflation that is too low, on the other hand, generally prompts actions to boost economic growth. This system seemed to perform well in the 1990s, when America enjoyed a stretch of rapid growth alongside low and stable inflation.

Since then, however, its shortcomings have become plain. In a world of falling real interest rates (ie, adjusted for inflation) a background rate of inflation of 2% is too low to prevent nominal interest rates from repeatedly falling to zero, at which point central banks can no longer rely on their favoured stimulative policy tool, an interest-rate cut. And too often, a focus on preventing inflation from rising above the target has led central banks to rein in economic expansions before the economy has clearly reached its capacity. The overall effect has been to depress employment and wage growth unnecessarily.

Economists and central bankers spent much of the past decade debating how best to correct these defects. Some argued that monetary policy should focus on the level of prices rather than the rate of increase: if inflation was too low for a while, that period must be followed by an offsetting one of higher-than-normal inflation, so that prices return to trend. Others reckoned that an inflation target should be swapped for one for money wages or GDP. In the era of inflation-targeting, prices seemed to become ever less responsive to changes in employment and output, which gave monetary policy a bias against dramatic action.

The “natural rate of unemployment”, above which price increases tend inevitably to accelerate, has been a part of the intellectual basis of monetary policy for nearly half a century. Although the Fed’s statutory remit has, since 1977, included both maximum employment and stable prices, policy has in practice focused on the maintenance of low inflation as the surest route to sustainable growth. The new adjustments hold the potential for a sea change in the way monetary policy is conducted.

Mr Powell’s revisions unquestionably reinstate full employment as an equal part of the central bank’s “dual mandate”. The Fed has given itself permission to resist the urge to tighten monetary policy when inflation is close to 2% and job growth is robust (a temptation that Mr Powell did not resist in 2018, when the Fed raised interest rates repeatedly despite evidence that the economy remained well short of full employment). Neither Ben Bernanke nor Janet Yellen, Mr Powell’s two predecessors, managed to adopt such a profound change during their tenure, even as the inadequacy of the status quo became increasingly clear.

But the Fed stopped short of committing itself to a more aggressively reflationary policy framework. The new strategy will give the central bank room to accept above-target inflation. But it will not require it to pursue such a path in pursuit of full employment. Neither is it clear that a target of 2% on average will significantly reduce the time the economy spends with interest rates stuck impotently close to zero. In a zero-rate world, this strategy overhaul could amount to little more than a promise not to counteract any government efforts to boost growth using fiscal stimulus.

In the end, Mr Powell’s review produced a welcome change in response to past failures and legitimate criticism: a rare achievement for an American institution these days. But, given the bleak outlook for the American economy and the low risk of embracing a more radical overhaul, this nonetheless feels like an opportunity missed.