Update 474: Monetary Policy Reimagined
What the Fed’s Momentous Moves Mean
With no recent fiscal action from Congress, all eyes have been on the Federal Reserve. Leery of criticism of TARP and other financial policy responses during the Great Recession, the Fed recently announced a series of new changes to its approach. These changes may augur a new era of the Fed, reimagining its foundational purposes, policies, and programs.
Clearly, the economy is in dire straits, and the Fed knows it. But it can’t act alone. Congress may need to come to an agreement on further fiscal relief and stimulus, perhaps as the best or only way for the Fed to succeed in getting the nation on the most effective path to economic recovery.
Good weekends, all…
Earlier this week, Federal Reserve Chair Jerome Powell announced the Fed’s intention to keep interest rates near zero through 2023 or until inflation reaches and moderately exceeds two percent “for some time.” The announcement follows another recent change by the Fed in August to significantly alter its monetary policy strategy to accommodate faster wage growth by no longer focusing exclusively on inflation. The Fed had begun its strategic review in response to criticism that it had cut off its expansionary efforts too early in the aftermath of the Great Recession.
But what do these choices mean for the economy and the potential recovery? And what does this mean for Fed action post-COVID? Below, we explore the changes and their potential impact on recoveries present and future.
In Memoriam of the Phillips Curve and Above-Zero Interest Rates
The Fed adjusts interest rates, its primary monetary tool, to achieve its dual mandate: price stability and maximum employment. According to the prominent Phillips curve, unemployment rates and prices (or inflation) are inversely correlated. This theory has played a significant role in monetary policy until recently.
After years of steadily decreasing unemployment and simultaneously low inflation, Fed officials have announced that they are reexamining the utility of the Phillips curve. Globally, various European nations and Japan have encountered the same flat Phillips curve. The Fed’s new approach to interest rates indicates the potential end of the Phillips curve as a fundamental model for monetary policy decision-making.
The Federal Reserve now expects interest rates to sit at near-zero for years, at least through 2023. This policy announcement is in response to two major challenges: the pandemic and slipping inflation rates, which threaten economic stagnation. The Fed’s strategy of keeping rates low and targeting higher inflation will lower borrowing costs to near zero in the long-term, providing an incentive to both the private industry and Congress to borrow. Despite the Fed’s positive adjustments to its economic growth and employment forecasts, the announcement to keep rates down through 2023 conveys a belief in a slow, painful recovery.
Not Your Average Inflation Target
Following double-digit annual price growth in the late 1970s, the Fed has focused on fighting inflation. But in recent years, it has struggled to meet its two percent inflation target. Last month, Fed Chair Powell announced a shift in how the central bank targets inflation, allowing it to average two percent in the long-term. This new target, prompted by fears of consumer inflation expectations falling below two percent, will permit inflation to overshoot its two percent target after periods of under-performance.
A statutory remit has required the Fed to keep prices stable since 1977. But for many years, the Fed did not have an explicit target inflation rate, targeting a range around two percent instead. This changed in 2012 when former Fed Chair Ben Bernanke set a two percent target inflation rate, matching the target of many other major central banks. Powell’s announcement in August consequently marks an important departure from the status quo.
In a world of falling real interest rates, an inflation rate under two percent is likely too low to prevent nominal interest rates from falling to zero during an economic crisis. When nominal rates hit zero, central banks can no longer rely on interest-rate cuts alone to stimulate the economy. This point of constrained monetary policy, known as the “zero lower bound,” could be mitigated by higher inflation. This would raise real interest rates and increase the scope for rate cuts during a recession.
At this week’s press conference, Powell stated that Board Governors were entirely confident that they would be able to hit two percent in the longer-run. It remains unclear how the Fed expects to push inflation towards two percent or even overshoot its target, so the target may not be credible.
Implications for Unemployment, Inequality
The Fed also revised its approach to the other half of its dual mandate: achieving maximum employment. As of last month, the unemployment rate is hovering around 8.4 percent, and about a million new Americans are still filing for unemployment each week. Prior to the pandemic, unemployment reached a 50-year record low of 3.5 percent. Economists at the Fed had previously assumed that maximum sustainable employment would coincide with an unemployment rate slightly above four percent and that any lower rate would cause excessive inflation.
These expectations caused the Fed to hike rates several times in the middle of the recovery from the 2008 financial crisis. The Fed justified its first hike in December 2015 by pointing to declining unemployment as an indication of future price increases. Yet the US has not experienced significant inflation since the early 1980s even during periods of extremely low unemployment. In retrospect, the Fed’s rate hikes likely slowed the economic recovery, damaging long-term financial prospects for many low-income workers with negligible benefit.
The Fed’s August strategic review altered its approach to achieving maximum employment by reorienting Fed action specifically around shortfalls, rather than deviations from an estimated level of maximum employment. Under this new interpretation of its mandate, the Fed will no longer raise rates when unemployment is lower than an estimated optimal level, slowing economic growth potentially before a recovery is complete.
Such a change should have dramatic effects on the Fed’s work to reduce unemployment during economic recessions and their subsequent recoveries. The statement also defines employment broadly, requiring the Fed to consider whether certain groups of workers are suffering from higher than average unemployment. This change cements the instructions of the 1978 Humphrey-Hawkins Act, which required the Fed to reduce disparities in unemployment rates and which Congress had up to now been unwilling to enforce. By looking at unemployment broadly, the Fed’s changes may have a wide impact on inequality by promoting a swifter and longer economic recovery, which would primarily benefit the lowest-paid workers who are most vulnerable to economic downturns.
Fed to Congress: Fiscal > Monetary Policy
During the coronavirus pandemic, the Federal Reserve has been notionally central to relief and stimulus efforts. But despite its recent changes, the Fed and monetary policy can do just so much. Fed Chair Powell has repeatedly exhorted on the need for further fiscal relief. Even President Trump is weighing in, pressuring congressional Republicans to work for relief much greater than their “skinny bill.”
The Fed’s latest forecast that prompted the announcement of near-zero rates through 2023 assumes another congressional fiscal package. Should Congress fall short of the CARES Act, the Fed will need to re-evaluate its economic forecasts and policy. The Fed’s latest monetary policy changes are evidence that it is running out of effective tools to further stimulate the economy. The Fed has kept the markets flush, but it can do little more than it has for individual Americans and most of their businesses.