Fed’s new strategy for inflation and labour market

Summary

• The Federal Reserve declared a change in its policy decision-making approach to achieve maximum employment and stability in prices.
• The new strategy aims to allow for higher inflation and additional job growth over time.
• Fed has taken significant steps to help the economy recover from the economic fallout of coronavirus through its emergency lending programs and increasing liquidity.
• The Fed plans to reset the market and household psychology to anticipate higher prices and act out in directions that will help bring them.

On 27 August, a major policy change was declared by Federal Reserve Chairman Jerome H. Powell to achieve maximum employment and stability in prices as well as willingness to allow inflation to be higher than the normal to support the US labour market. The new plan was disclosed at the beginning of the annual central banking conference which promises to deal with the shortfalls arising from the wider objective of full employment.

The central bank has consented to a policy of average inflation, implying that it will allow inflation to run moderately above the 2% target for some time. The modifications were codified in a policy framework, first adopted in 2012, called the "Statement on Longer-Run Goals and Monetary Policy Strategy, which guided the Fed's approach to interest rates and general economic development.

The new policy indicates that the Fed is less likely to adopt the policy of increasing interest rates in response to a low rate of unemployment, so long inflation does not rise. The move indicates that the official overnight interest rate of the US central bank, which is now close to zero, will sit there for possibly years to come while policymakers attract higher inflation.

Traditionally, there has been a belief amongst central bank officials that low unemployment levels result in a higher rate of inflation. Nonetheless, Powell's speech given to a virtual gathering of the Fed's annual Jackson Hole, Wyoming, symposium and complementary documents that codified the new policy, marked a different approach from the conventional philosophy. All the modifications were unanimously approved by the policymaking Federal Open Market Committee.

Economic implications and risks of the new strategy

Inflation has run below 2% target for years, but the new approach adopted by Fed indicates that Fed officials will not consider increasing interest rates until inflation overshoots their objective of 2% for some time. The thought process behind this approach is that if households, as well as businesses, are assured that their buying power will reduce in future due to higher inflation, they will begin to spend, invest and borrow now.

The rise in spending in the crisis period will assist in creating jobs and strengthening demand, dragging the economy out of the coronavirus induced economic blues. Further, steps taken by the Fed to push unemployment lower can help in lifting up the labour market.

The conventional system showcases a fall in unemployment to quite low levels as an initial warning gauge for undesirable inflation. However, such a situation was never seen. The US unemployment rate had dropped to nearly 50-year lows prior to the coronavirus pandemic struck, and there was no evidence of an inflationary increase. This lesson has been taken into consideration in the new framework, making space for the Fed to hold policies loose even though jobs grow.

For the strategy to be a success, households and businesses must believe that Fed policymakers have switched their focus on making a stronger labour market from being inflation fighters. They must also understand that a bit of inflation is good for the economy. Further, holding interest rates down for a prolonged time period leans towards lifting the bond markets, helping possibly the rich section of Americans more than the less-privileged section.

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The path ahead still remains blurry

The comments made by the Fed policymakers showed their thinking for the longer term, which is created not to force decisions at individual Fed policy meetings but to structure how the central bank is establishing its goals. Gaining acceptance from people that the strategy will make a difference will occur with time. However, this would require weathering all developments in the economy and unavoidable shifts in Fed personnel that includes the possibility of a new chief after Presidential elections on 3 November.

The new approach by the Fed is both recognition of economic changes that started before the coronavirus pandemic happened and a path to conducting policy in future. Nevertheless, the strategic journey remains quite blurry. There is no clarity on the duration of time up to which the federal may keep low rates or how high the federal may allow inflation to go. Indeed, Powell stated that the Fed's new approach towards inflation could not be supported by an unambiguous quantitative model.

The central bank is anticipated to pursue outcome-based guidance for its key federal funds rate in September, pledging to keep it near 0 until inflation reaches a certain threshold. Hence, investors will have to wait until September for more specific guidance.

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