The Federal Reserve’s (Fed) August release of the revised “Statement on Longer-Run Goals and Monetary Policy Strategy” introduces a subtle but significant change to inflation policy. The Fed’s shift to targeting an average inflation rate of 2% over time (as opposed to simply a 2% target) represents an acknowledgment that one of the Fed’s primary economic forecasting tools, the Phillips curve, is officially dead. The Phillips curve models a trade-off or inverse relationship between unemployment and inflation. However, since the mid-1990s, inflation has remained consistently below the Fed’s 2% target even during periods of full employment. The Fed’s new approach incorporates the view that “a robust job market can be sustained without causing an unwelcome increase in inflation.”
Implications for the future path of interest rates resulting from the Fed’s more tolerant views on inflation were revealed shortly after the August revision. During the September Federal Open Market Committee (FOMC) meeting, the Fed extended the timeline for interest rates to remain at the effective zero lower bound for another year — through the end of 2023 — and added language suggesting inflation needs to be on track to run in excess of 2% for some time to increase rates. The extended lower-for-longer forward guidance comes even as the Fed’s own projections for economic growth and inflation increased across the board from June to September: U.S. 2020 gross domestic product increasing from -6.5% to -3.7%, 2020 year-end unemployment rate falling from 9.3% to 7.6% and 2020 personal consumption expenditure inflation increasing from 0.8% to 1.2%.
The new framework for inflation targeting also exposed a rift between the “hawks” and “doves” over how to communicate the Fed’s revised inflation policy. The dovish camp preferred more outcome-based forward guidance, which requires inflation to move above 2% for an extended period of time before moving rates off zero. The hawkish camp worried more explicit forward guidance would reduce flexibility and risk financial imbalances. The September FOMC statement settled for a middle ground, targeting inflation “moderately above 2% for some time.” The middle ground was not good enough for everyone, with Dallas Fed President Robert Kaplan dissenting among the hawks and Minneapolis Fed President Neel Kashkari dissenting among the doves.
The Fed’s recent changes to monetary policy strategy reflect its long-standing frustration with inflation running stubbornly below 2%. Investors may begin to worry whether policymakers will soon regret the timing for the shift. With the next administration in Washington likely to “spend big” for the next round of fiscal stimulus and the Fed standing ready to pay the bills, reaching and possibly exceeding the new inflation target may come more easily than policymakers and investors expect.