The Federal Reserve will soon reveal a subtle yet profound shift in how it conducts monetary policy for the world’s largest economy, officially embracing a more relaxed view on inflation.
In addition to helping rescue the U.S. economy amid the coronavirus pandemic, Fed Chair Jerome Powell and colleagues also spent 2020 finishing up the central bank’s first-ever review of how it pursues the goals of maximum employment and price stability set for it by Congress. It’s a process that began in early 2019 and included a nationwide listening tour.
Now they’re close to presenting the results -- perhaps as soon as September.
“It will signal clearly to the market that not only will the Fed tolerate inflation temporarily above 2%, but that it favors it, and will try to aim in that direction,” said Mickey Levy, chief economist for the U.S. and Asia at Berenberg Capital Markets.
Several other economists interviewed made precisely the same prediction and agreed that many Fed officials have already been pursuing that strategy for months. Investors also see it coming.
The 10-year breakeven rate, a market-based gauge for expected annual inflation over the next decade, has rebounded to 1.66% from as low as 0.47% in March.
“Rising inflation expectations are, in part, indicative of the market beginning to price in the Fed’s shift,” said Bill Merz, senior portfolio strategist and head of fixed-income research at U.S. Bank Wealth Management in Minneapolis.
More details on when and how the Fed will wrap up its review may be revealed this week when the central bank releases minutes to the July 28-29 meeting of the Federal Open Market Committee.
The shift in how the Fed seeks to control inflation may sound meager, but it’s meaningful.
The Fed first pronounced a 2% target for inflation in 2012, and officials took that to mean they would always shoot for 2%, no matter how much or for how long they missed. Bygones, they said, would be bygones.
But the Fed’s preferred measure of inflation has consistently fallen short, averaging just 1.4% since the target’s introduction.
That’s a vexing problem for central bankers. Combined with low economic growth, it means interest rates have remained historically low. That’s squeezed away the Fed’s ability to fight off future economic downturns, making them deeper and longer, costing more jobs and destroying more businesses.
The current, pandemic-induced recession is the perfect example. The lower end of the Fed’s target range for its benchmark rate sat at a mere 1.5% when the crisis struck. Officials promptly slashed it to zero in just two moves in March, but that was nowhere near a sufficient response to the worst downturn since the Great Depression.
Once again the Fed was forced to make massive bond purchases to stabilize markets and push down real borrowing costs. It’s not clear yet how effective those measures will prove.
The issue, however, was clear even before Covid-19 hit the U.S., and by early 2020 many Fed officials had already come to the view they’d be better off sometimes pushing inflation modestly above their target so that, over time, it roughly averaged 2%.
“The Fed needs to acknowledge there’s a cycle with inflation,” said Ethan Harris, head of global economic research for Bank of America Corp. “Some overshooting late in the cycle makes sense.”
For some Fed watchers, such a conclusion to the much-ballyhooed framework review will seem a dud.
Officials chewed over, but ultimately rejected, a slew of more daring proposals, from raising the inflation target to abandoning it for a nominal GDP target. They were also cautious in re-examining what they might do when rates hit zero.
They decided negative interest rates would be a bad option in the U.S. and haven’t warmed to the idea of capping the yields on some Treasury securities -- known as yield-curve control -- though they haven’t entirely ruled that one out.
In the end they see their current tools -- bond purchases and communication on the future path of interest rates -- as still the best options. Atop that they will add the important wrinkle that inflation should average close to 2% over time.
The shift, however, will only go so far. When the Fed articulates its new embrace of inflation averaging, officials likely won’t apply it in rule-like fashion, economists said, and may not even mention the word “average.”
“They’ll use language that will convey the notion that the Fed has total, total discretion,” Berenberg’s Levy said.
From the beginning of the review, Fed Vice Chairman Richard Clarida promised “evolution, not revolution,” and that seems to be what the central bank will soon deliver. But the question for the Fed as it wraps this review is: Will it be enough?
As Peter Hooper, global head of economic research for Deutsche Bank AG, put it, “Have we really increased the store of ammunition and the weapons one can draw on to deal with this problem?”
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