On the day of Chairman Powell’s opening speech for this year’s virtual annual Jackson Hole Economic Policy Symposium, hosted by the Kansas City Fed, the Federal Reserve released an update to its January 2012 “Statement on Longer-Run Goals and Monetary Policy Strategy.” This commentary describes the changes in the strategy and discusses what may be some difficult challenges for the Federal Reserve System in implementing and communicating strategy under this new policy.
There are several important changes in the highlighted version of the statement. We’ll take them paragraph by paragraph. In the second paragraph, the Committee’s objectives were rearranged by putting employment ahead of inflation. The Committee notes that the federal funds rate target consistent with its employment and inflation objectives has declined relative to where it was in the past, and as a consequence there is now greater concern about the zero-rate constraint on the lower bound of the policy rate. As a result, the Committee is more concerned now about downside risks. Committee goes on to emphasize that it will employ the full range of tools (unspecified) as needed to achieve its objectives.
In the third paragraph, the statement indicates that the determinants of what constitutes full employment vary over time, depending upon the structure and dynamics of the labor market; and as a result, the Committee will not specify a numerical target for employment. Rather, it will focus its policy concerns on shortfalls from what it believes to be full employment. In his address to the Jackson Hole Symposium, Chairman Powell suggested that the Committee would not be concerned if employment exceeds what the Committee views as full employment, as long as there is no indication that its inflation objectives are at risk. This clearly suggests that either there is now a de-emphasis on the Phillips curve or that the curve is so flat that the implied relationship between tight labor markets and inflation has little or no relevance for policy. It was also clear from his remarks that the information on the benefits that the historic low unemployment rate had for low-income workers and minorities gleaned from the series of Fed Listens events was important in establishing the new employment objectives.
Perhaps the most important and startling change in the policy is described in the fourth paragraph, which lays out the Committee’s approach to its inflation objective. Instead of a static 2%-point estimate target for longer-run inflation, the Committee has adopted what Chairman Powell described as a “flexible average inflation target.” One implication is that when average inflation runs below target, the Committee will subsequently tolerate inflation moderately above the average so as to “make up for the shortfall.” Missing from the statement is an elaboration of the role that inflation expectations would play. While Powell indicated that he viewed expectations as well anchored for the moment, he suggested an unusual role for expectations and how they might affect interest rates and future inflation. If inflation expectations were persistently below target, this would put downward pressure on interest rates and that dynamic might beget a downward spiral in actual inflation that would be difficult to counter. This scenario harkens back to the concern about the zero bound for policy rates and the ability of the Fed to respond when cuts in rate are called for.
The statements in the final three paragraphs address policy lags. Again, Powell clarified in his symposium remarks that the Committee views its current policy stance as being largely consistent with its employment and inflation objectives. However, if employment shortfalls from full employment or inflation deviates from its target , the Committee will pursue a balanced policy, taking into account the potential different time horizons for employment and inflation to adjust.
When it comes to the shift in how the Committee views its inflation objective, much was left unsaid, and careful consideration suggests that the new approach may actually complicate the policy process in terms of both implementation and communication. Powell stated, for example, that the Committee would not take a formulaic approach to policy; but, of course, to target an average inflation rate is to employ a formula. Presumably, what he meant was that the Committee will not employ a rule or formula when policy needs to change. But there are also deeper questions involving the approach, and here are but a few:
- The statement does not specifically state that the inflation index will be the PCE, whereas in the past Powell has referenced the trimmed PCE mean in some discussions. The actual rate being targeted should have been reaffirmed in the statement, especially since TIPS are tied to the CPI. Is it still the PCE, or something else?
- The approach does not deal with the time horizon over which the average will be targeted, nor does it specify whether the average targeted inflation rate will be year-over-year, three-month, six-month, or some other interval.
- How large a standard deviation will be tolerated before a policy change is initiated?
- How long must actual inflation be above or below the target before a policy change is made?
- How will the Committee implement policies to restore inflation to the target average when deviations are sufficient to move the average off-target, do the policies vary depending upon the size of the deviations, and how long will it take to do restore the target to 2%?
- Powell made the point of emphasizing policy lags, but how do those lags impact the timing of a policy move for a given departure of inflation from the target?
- Because movement in an average will lag movements in current inflation, doesn’t this guarantee that the FOMC will be behind the curve in reacting to inflation?
These are but a few of the kinds of questions that pose challenges to the Committee as it attempts to administer policy and then explain its reaction functions to the public.
Finally, the elephant in the room is the fact that the Committee has pursued a 2% inflation target since January 25, 2012, but has continually undershot that level. To get the target average up to 2%, inflation will have to be greater than that. How will this be achieved? Perhaps the first step is to ask, If the average 2% target had been in place in 2012, how would the inflation situation been different before the onset of the pandemic crisis, and what has the Committee concluded it should have done differently to achieve the average 2% objective if it had been in place?
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