Federal Reserve Chairman Jay Powell on Thursday announced a significant shift in the central bank policy regime that moves away from its long held Phillips Curve-based trade-off between employment and inflation. This will provide the Federal Reserve more room for accommodation in an era of zero interest rate policy and position the central bank to support maximum sustainable employment without running the risk of higher inflation expectations and actual inflation. While this may seem a small technical adjustment to policy, it carries significant long run consequences for the American economy.
This shift in policy is driven by long term changes to the underlying structure of the economy toward slower growth, a reduction in the neutral rate of interest, or what economists refer to as r*, and the understanding that the economy can generate much lower unemployment without running the risk of higher inflation.
Under the new framework, the Fed will no longer move in anticipation of higher inflation associated with lower unemployment around its 2% inflation target. Rather, the Fed will now let the economy run “hot” and inflation rise above its 2% target for a time without risking the anchoring of inflation expectations. Thus, policy variable-core PCE inflation runs at 1.5% over a five year period, the Fed would be quite comfortable permitting inflation to run at a 2.5% rate over the next five years without running any risk to its target.
In some ways, this encapsulates and institutionalizes former Fed Chair Ben Bernanke’s flexible inflation targeting regime and former Fed Chair Janet Yellen’s lower-for-longer interest rate policy. It is the logical next step in the evolution of monetary policy. Moreover, it gives the central bank a tremendous amount of flexibility to respond to exigent circumstances such as a massive second wave of the pandemic next winter or to address another policy fail by the fiscal authority if the current policy polarization in Washington, D.C. endures.
In our estimation, the new inter-temporal policy framework is a much needed regime change that is appropriate given the structural changes and demographic changes in the economy. Moreover, the central bank policymakers during their “Fed Listens” tour clearly picked up on the broad, deep and enduring social change that is occurring in the economy and country. One denotes a shift in policy that has been influenced by demands for social justice that is clearly front and center in the economy. In the update to its Statement on Longer-Run Goals and Monetary Policy Strategy, the Fed hinted at an asymmetrical shift toward maximum sustainable employment that will favor minorities who traditionally suffer from higher unemployment than the majority demographic. This clearly will support policy organized around at targeting low and moderate income communities.