Overview
Chairman Powell's highly anticipated speech at the online Jackson Hole Symposium confirmed what had been expected for a while: the Federal Reserve has shifted towards a new strategy for monetary policy with 'average' inflation targeting at its core. This will allow inflation to "moderately" overshoot the target (which remains at 2 per cent) for some time, to compensate for persistently low inflation in the run-up to the Covid-19 crisis.
The Fed has also modified its employment mandate. It will now focus on "assessments of the shortfalls of employment from its maximum level", instead of "deviations from its maximum level". This means the Fed's reaction function to unemployment will become asymmetric, whereby the Fed will be more likely to ease policy when unemployment is perceived to be higher than optimal.
Following the experience of the last decade, the Fed has concluded that the Phillips curve has flattened, giving the central bank more confidence that employment can run at or above its maximum level without causing inflationary pressure. Ironically, it is possible that Covid-induced changes of a more structural nature may bring out higher inflation earlier than anticipated by the Fed and markets. The risk of inflation surprising to the upside over the next 2-3 years does seem to be skewed to the upside. Time will tell.
Overall, the Fed's new framework will certainly introduce more flexibility into how it might conduct monetary policy in the future. This should be viewed as a desirable change, given the post-financial crisis experience as well as elevated uncertainties related to the 'new normal' post Covid. While more flexibility could mean less predictability, especially as the key building blocks of an inflation targeting regime - such as the Taylor rule and the Phillips curve - seem to have now been made officially obsolete, the outlook for monetary policy in the foreseeable future could not be more predictable. The stage is now set for interest rates to remain at the effective lower bound (zero) for some time - perhaps several years - and the bar for rate hikes has been significantly lifted on both sides of the mandate.
All eyes will now turn to the Fed’s September meeting and what the new framework might mean for changes to forward guidance and other components of policy communication.
