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A New Monetary Policy


A tumultuous decade marked by a financial crisis and a global pandemic have led the Federal Reserve to seemingly abandon the "dual mandate" under which it has operated for the last 50 years.

Last Thursday, while almost 24 million Americans were gearing up to watch President Donald Trump’s Republican National Convention speech and the literal fireworks that followed, Federal Reserve Chair Jerome Powell gave an historic speech of his own that sent rockets around the monetary policy world.

In remarks that were webcast from Jackson Hole, Wyo., Powell made this radical statement: “[A] a robust job market can be sustained without causing an outbreak of inflation.”

While recent history bears out that statement — the U.S. unemployment rate was at a 50-year low at the end of 2019 before the coronavirus pandemic took hold while inflation was at just 2.3 percent, a rate considered “low” — the statement upends a framework that the Fed has held to for more than four decades.

Since 1977, the Fed has had two objectives, outlined by Congress: to keep prices (i.e., inflation) stable and to promote full employment. (To be clear, “full” employment historically has not meant zero percent unemployment. Economists generally consider a five percent jobless rate to be “full” employment.)

As New York magazine reporter Eric Levitz noted, these two objectives — referred to as the Fed’s “dual mandate” — have been “long presumed to be in tension.” That was because it was thought that if unemployment fell too low “workers would gain the upper hand on their bosses and demand wage gains in excess of their own productivity, which would force companies to raise the prices of their goods to keep up with their labor costs, which would then cause workers to demand still-higher wages to keep up with prices, in a vicious inflationary cycle.”

As of last Thursday, that belief is no more, at least for now.

In his remarks, Powell announced that Fed policy decisions now “will be informed by our assessments of the shortfalls of employment from its maximum level rather than by deviations from its maximum level.” As New York magazine’s Levitz explained, the Fed also announced it will not treat its two percent inflation target “as a maximum, but rather as the average rate it wishes to promote over an extended period of time.” That means “if inflation runs a bit below that target for years on end, then the Fed will tolerate inflation a bit above that target for a few years after.”

Powell also explained what has not changed in the Fed’s interpretation of its congressional mandate. Powell noted, for example, that the Fed still believes it is “unwise” to set a “numerical goal for employment.” He also said the Fed has not altered its “view that a longer-run inflation rate of two percent is most consistent with our mandate to promote both maximum employment and price stability.” The Fed also will continue to take the view that “monetary policy must be forward looking, taking into account the expectations of households and businesses and the lags in monetary policy's effect on the economy.”

The new policy is the result of an 18-month, first-of-its kind review of the Fed’s monetary policy, Powell explained.

What are the implications?

Because interest rates were expected to remain very low for the foreseeable future anyway, Greg Ip, The Wall Street Journal’s chief economics commentator, said the practical impact of the shift would be “small,” at least in the near term.

Still, Powell’s words reflected an “important institutional and philosophical shift,” Ip said, and “one comes in response to a changed world.” Former Fed Chair Janet Yellen agreed. She told The New York Times that the announcement “seems like a pretty subtle shift to most normal human beings,” but “most of the Fed’s history has revolved around keeping inflation under control.” She concluded, “This really does reflect a decisive recognition that we're in a very different environment.”

Under the Fed’s previous policy, Ip explains, the Fed tried to avoid unemployment rates that were both too high and too low. By replacing the word “deviations” with “shortfalls” in its policy the Fed, according to Ip, has stated it now believes there is no such thing as an unemployment rate that is too low. (The rate, of course, can still be too high.) Additionally, as Forbes contributor Robert Barone explains, now “if inflation rises above two percent the Fed won’t have to react.”

While The Washington Post said the Fed’s announcement was “not flashy politics,” it does reflect changing social dynamics and pressures. Ip noted, for example, that Democrats are “demanding that the Fed explicitly target racial disparities in unemployment and wealth.”

Last week’s action seems to respond to that view, at least somewhat. Ip said, “By elevating the primacy of full employment, the Fed’s new framework implicitly addresses racial gaps without making them an explicit target.” New York magazine’s Levitz agreed. He implied the Fed’s shift could have “profound stakes for inequality and social justice.” (Levitz also used some more blunt language, arguing that “Powell has made it a bit easier for America’s working-class majority to prevent its ox from being gored” by wealthier interests.)

For homebuyers, last week’s announcement likely means the continuation of low interest rates. Indeed, Forbes’ Barone said the shift means interest rates will be “minuscule as far as the eye can see, and for a much longer period than would have been the case under the replaced policy.” Mortgage Reports editor Peter Warden said mortgage rates could be low “for years.”

Lower interest rates also will make it cheaper for entrepreneurs to get loans for new businesses, Warden reported. Americans with other types of debt, from student loans or credit cards, will benefit too from the move since low interest rates will make it easier to pay down their debt.

The shift will have some negative effects for individuals nearing retirement, however, said Marketwatch reporter Alessandra Malito. That’s because, “The closer someone gets to retirement, the more likely their portfolios are to represent conservative investments, such as bonds.” Larry Luxenberg, principal at Lexington Avenue Capital Management, told Malito, “Truly safe investments won’t yield much.”

As The Journal’s Ip explains, last week’s announcement was not the Fed’s first shift in mission in its 107-year history. Ip explained Fed priorities “were revamped during the Great Depression to better manage the broader economy.” And, of course, back in 1977 after “inflation and unemployment both rose throughout the 1960s and ’70s, Congress responded by amending the Federal Reserve Act to make maximum employment and stable prices the Fed’s goals.”

Nor is the change outside the norms of what the Fed has practiced.

Indeed, as Wall Street Journal economics reporter Nick Timiraos said, “The changes take the Fed back to the 1930s and 1940s, when its leaders were animated by an emphasis on improving the labor market.” Timiraos quoted a book on Fed history by George Washington University political scientist that noted, “Bolstering jobs — more so than curtailing inflation — dominates the political history of the Fed.”

Still, last week’s move sets the U.S. central bank apart from others across the globe. As Gabriel Sterne, head of global strategy services and emerging markets macro research at Oxford Economics, explained to CNBC back in April, “Most central banks do inflation targeting.”

Sterne predicted the coronavirus pandemic could change that. He argued, “Financial markets have been way better at predicting inflation than central banks are. I think the whole framework now has lower credibility internationally than it has since inflation targets were started in the early 90s.” Sterne concluded, “I think coronavirus will definitely have a big impact on inflation and views towards policy — I think it could tip the monetary frameworks over the edge.”

The Fed’s shift was in the works well before last week’s announcement, or before Sterne’s prognostication.

Will other central banks follow?

While The Washington Post is right that the Fed announcement isn’t “flashy politics,” the political ramifications of the announcement are interesting. Chair Powell’s term at the helm of the Federal Reserve Board expires in 2022 and standing with influential members of both parties, including President Trump in particular, has been marked by strife and disagreement. Though the Fed has been moving in this direction informally for some time, the results of the November elections may have something to say as to whether the decision will outlast him.

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