The Federal Reserve’s new strategy statement will likely result in higher inflation and more volatile inflation. The higher inflation is welcome, at least by the Fed. The more volatile inflation rate and economic cyclicality may not be expected by them.
Federal Reserve Chairman Jay Powell explained the new strategy at the annual monetary policy conference, usually held in Jackson Hole but conducted online this year. Powell’s speech noted four major changes in the economy in recent years. First, estimates of long-run potential growth of the economy have declined. Second, interest rates have fallen. Third, our long expansion after the recession of 2008-09 led to a great labor market, which especially help disadvantaged people. And fourth, the strong labor market did not lead to higher inflation. Powell’s four points are factually correct.
The Fed is afraid of inflation running too low. This fear is the basis of the new strategy. Powell explained that if inflation is sometimes less than the Fed’s two percent target and sometimes at the target but seldom above target, then the average will be below the target. That will drive expectations of lower inflation, which will pull interest rates even lower. When a recession comes and the Fed wants to stimulate the economy, it will have little room to cut interest rates. Higher average interest rates provide more flexibility, in the Fed’s opinion. Not everyone will agree with that, especially those who believe quantitative easing has power beyond pulling interest rates down.
As a result, the Fed plans to push inflation above two percent after periods of below-target inflation, so that the average hits two percent.
The second change in the Fed’s strategy prioritizes job growth. In the past, the Fed tried to hit a maximum employment estimate and would respond symmetrically to avoid overshooting as much as undershooting. The fear of overshooting-too much employment-was that it would trigger inflation acceleration. The Fed will now ignore employment above its estimate of the maximum.
The change is motivated by two factors. First, as Powell noted, the strong employment market was very beneficial to Blacks. It was also the best job market ever for high school dropouts with prison records regardless of their race. Employers were not seeking out such people, but rather hiring whoever was available. In the context of Black Lives Matter concerns, economic conditions that are favorable to disadvantaged people are more important than previously.
The second motivation for the change is the difficulty of forecasting inflation and understanding how labor market conditions affect inflation. This is not just the Fed’s difficulty. Private sector forecasters have found that their old models predicted poorly in recent years. Given distrust of the inflation forecasting models, the Fed won’t rely on them to tighten monetary policy to prevent inflation.
Combine that change with comments from the Fed’s July Open Market Committee minutes, which said that they wanted to see achievement of target outcomes before changing policy. My interpretation is that the Fed will not tighten monetary policy when it predicts inflation is about to accelerate-it will wait until inflation does accelerate.
The result of these changes in Federal Reserve policy will be more stimulative actions, pursued over a longer time period. The Fed will not reverse course, to a more restrictive monetary policy, until it actually sees inflation rising.
This is what you would do driving a sports car down a steep hill: hit the brakes when your speed becomes excessive. But it is not what a good driver of a heavy truck would do. The driver would anticipate the truck’s acceleration and start braking early, knowing that waiting until the truck was going too fast would be dangerous. So what’s the economy like, a sports car or a semi? In practice, the time lags in monetary policy are substantial. Output, employment and income will begin to respond within a quarter or two of the Fed’s action, but the full effect will be at least two years out. Inflation responds even later. So if the Fed wants immediate action, it must take very strong steps, then reverse them before the lingering effects take hold. This implies a level of precision lacking in econometric models of the economy. So delaying action until inflation actually accelerates guarantees overshooting.
Here’s what the United States can expect from these policy changes. Inflation will rise a little. Add to the Fed’s new strategy their recent tactics: huge stimulus. And those who don’t think monetary policy is particularly effective can focus on the hug federal government expenditures. Yet the stimulus cannot be matched by increased production of goods and services. The economy was running labor-constrained until Covid-19 hit us, and now it’s further constrained by social distancing requirements. More dollars, with fewer goods and services available to buy, makes a formula for inflation.
When the Fed does see inflation, it will have to hit the monetary brakes. But it’s actions won’t take effect right away. While the Fed is waiting for the economy to respond to its tightening, inflation will continue to accelerate. This may well prompt the Fed to even greater tightening. Look for a more cyclical inflation rate, as well as a more cyclical path for business sales and profits, in the coming years.
Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.