Powell emphasised four changes in the US economy since the Fed implicitly adopted an inflation objective in 2012:
- The potential growth rate of the economy has fallen. That reduces the real interest rate.2
- Interest rates have fallen across the world, partially because growth rates have declined and partially because inflation and expected inflation have fallen. Low interest rates mean that the Fed has less room to cut interest rates in a downturn, so monetary policy becomes less effective.
- Until Covid, the US labour market had been exceptionally strong. A strong labour market brings many benefits, in particular for minorities and other economically disadvantaged groups who tend to be on the margins of the labour market.
- The Phillips curve appears to have flattened in the sense that tight labour markets seem to trigger less inflation than previously. One reason for that may be that inflation expectations have declined to very low levels.
Powell noted that inflation has been below the Fed’s objective for some time. He said that that is dangerous, because lower inflation comes together with lower expected inflation and therefore lower interest rates. This reduces the room for the Fed to cut rates if a negative shock occurs. It is therefore essential for the Fed that inflation expectations do not fall below 2%.
He announced two important changes to the Fed’s policy framework, but also noted that these revisions reflect the Fed’s actual conduct of policy in recent years, which suggests that policy might not change much in the near term:
- The Fed’s thinking about the labour market has changed. Maximum employment is now seen as a broad-based and inclusive goal. Policy decision will be dependent on “shortfalls of employment from its maximum level" rather than by "deviations from its maximum level." The Fed evidently thinks that the labour market can be run a little hot without necessarily triggering a burst of inflation.
- The new framework entails the Fed seeking to achieve an average inflation rate over time of 2%. If inflation stays below 2% in downturns but does not move above 2% in booms, the average inflation rate will be below 2%. Inflation expectations will then fall, pushing down inflation. The Fed will therefore in this case seek to achieve an inflation rate of moderately above the 2% objective for some time following a period of low inflation.
Importantly, there would be “no particular mathematical formula that defines the average.” The Fed thinks of its new framework as “flexible average inflation targeting” and policy will continue to be based on a range of considerations.
What will these changes imply for the future? On balance, they are likely to make monetary policy a little more expansionary in the coming years as the Fed seems determined to push inflation above 2% for a period of time. If it achieves that, higher actual and expected inflation suggests marginally higher interest rates in the longer run.
That said, it is not clear how effective this change will be in raising inflation in the short run. The experiences of Japan, which has been trying for a quarter century to raise inflation and failed, show how difficult it can be raise inflation in certain circumstances. In theory, Chairman Powell's announcement should already raise inflation expectations now. With the federal funds rate at (almost) zero, the expected real interest rates will then fall. As average core inflation since 2015 has been about 1.6%, it may be that the Fed will seek to achieve a rate of 2.4% for some time. If so, the expected real interest rate may fall by 0.8%. This might not be enough to trigger a rapid rise in actual inflation.