There was very little chance the Federal Reserve was going to raise interest rates anytime soon but, just to make sure, the Fed’s rate-setting Federal Open Market Committee gave itself a dual justification for holding rates down indefinitely with the new monetary policy framework it announced on August 27.
Not only did the FOMC give itself permission to overshoot the 2% inflation target it unveiled in January 2012, it unhitched itself from the much longer-running Phillips Curve premise that falling unemployment leads inexorably to rising wage-price pressures.
Some might think that this preemptive revision of the Statement on Longer-Run Goals and Monetary Policy Strategy renders the upcoming meeting meaningless.
Not so. Already, it has had an effect on market expectations and yields, and the new strategy statement is sure to colour policy discussions at this and subsequent meetings.
What’s more, it opens the door to further changes in the way the Fed does business.
More on that later. First, let’s look at the new strategy statement.
One way of looking at it is that the revisions are no big deal – that they merely perpetuate the status quo of policy making. Encouraging that view, Fed Vice Chairman Richard Clarida observed, “it’s more evolution than revolution” – a sentiment with which Chairman Jerome Powell concurred.
In a sense that’s true: After all, Powell said any overshooting of inflation would be “moderate” and that the FOMC is not going to be following any “mathematical formula”. In other words, it will be using its own “flexible” discretion, just as it always has, in setting interest rates, calibrating asset purchases and so forth.
No big deal.
But, in fact, the new statement has significant import for policy, both short and long term.
Looking beyond the immediate crisis, it imparts an unmistakable and lasting dovish bias to US monetary policy that could become more and more evident and consequential as we recover from the recession caused by forced closures to fight the coronavirus. It likely will incline the FOMC to be even more aggressive in trying to “support the economy”.
Getting the most attention was the FOMC’s shift from a “symmetric” 2% inflation target to average inflation targeting, but its restatement of its maximum employment goal is arguably just as important. Indeed, the FOMC elevated that part of the dual mandate to higher up in the statement.
Regarding its “maximum employment” objective, the FOMC now says policy will be “informed by assessments of the shortfalls of employment from its maximum level”. Previously, it had referred to “deviations from its maximum level”.
Big difference, as Powell explained: “The change to ‘shortfalls’ clarifies that, going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals. Of course, when employment is below its maximum level, as is clearly the case now, we will actively seek to minimise that shortfall by using our tools to support economic growth and job creation.”
In other words, the Fed will no longer allow itself to be stampeded into raising rates when unemployment falls to below hypothetically “natural” levels on the presumption that low unemployment will inevitably push up inflation, as it has done so often in the past.
The concept of “overheating” is seemingly out the window. Now the Fed is advertising its willingness to let the economy “run hot”.
As Clarida explained a few days after the revised strategy statement was adopted, “This change conveys our judgment that a low unemployment rate by itself, in the absence of evidence that price inflation is running or is likely to run persistently above mandate-consistent levels or pressing financial stability concerns, will not, under our new framework, be a sufficient trigger for policy action.”
Clarida said “this is a robust evolution in the Federal Reserve’s policy framework and, to me, reflects the reality that econometric models of maximum employment, while essential inputs to monetary policy, can be and have been wrong and, moreover, that a decision to tighten monetary policy based solely on a model without any other evidence of excessive cost-push pressure that puts the price-stability mandate at risk is difficult to justify, given the significant cost to the economy if the model turns out to be wrong and given the ability of monetary policy to respond if the model were eventually to turn out to be right.”
Regarding its “price stability” goal, the FOMC now “judges that longer-term inflation expectations that are well anchored at 2% foster price stability and moderate long-term interest rates and enhance the Committee’s ability to promote maximum employment in the face of significant economic disturbances. In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2% over time, and therefore judges that, following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.
What’s more, by saying it will be “flexible” and “not formulaic” in pursuing its new strategy, the FOMC made clear it will use more discretion than ever in setting rates and other policies.
How does this pertain to the September 15-16 FOMC meeting?
For starters, the meeting inaugurates a new era for US monetary policy – an era of allowing inflation to run above 2% to compensate for past periods below that erstwhile target and an era of letting unemployment run below the putative non-accelerating inflation rate of unemployment (NAIRU).
Policymakers will be operating under different assumptions and making their forecasts and assessments of appropriate policy accordingly.
The first place this might show up is in the quarterly Summary of Economic Projections, a compendium of all FOMC participants’ economic and funds rate projections, which is due to be updated at this meeting.
In the June SEP, the so-called “dot plot” showed a dramatic decline in the median funds rate projection over the next two years to 0.1% from 2.1% in the December 2019 SEP – understandably given the prevailing state of economic and financial conditions. It would be hard for FOMC participants to lower their funds rate projections for 2021-22, but unlike the June SEP, this one will include the first projections for 2023.
Expect that near zero funds rate projection to be extrapolated out another year. And the horizon could be more distant than that. On September 4, Powell told NPR, “We think that the economy’s going to need low interest rates, which support economic activity, for an extended period of time. It will be measured in years.”
The median longer run (or “neutral”) funds rate projection in June was 2.5%, but that bears watching. It wouldn’t be surprising if the longer run projection came down further, given that one of the reasons given for altering the longer run strategy was the belief that the real equilibrium short-term interest rate, and in turn the neutral funds rate, have fallen sharply.
Recall that, in January 2012, the FOMC’s estimate of the longer run neutral funds rate, including the real rate plus 2% inflation, was 4.25%!
The drop in r*, in part, forced the FOMC’s hand in revising the monetary strategy statement, as Clarida explained: “The substantial decline in the neutral policy rate since 2012 has critical implications for the design, implementation, and communication of Federal Reserve monetary policy because it leaves the FOMC with less conventional policy space to cut rates to offset adverse shocks to aggregate demand.”
“With a diminished reservoir of conventional policy space, it is much more likely than was appreciated in 2012 that, in economic downturns, the effective lower bound (ELB) will constrain the ability of the FOMC to rely solely on the federal funds rate instrument to offset adverse shocks,” Clarida continued. “This development, in turn, makes it more likely that recessions will impart elevated risks of more persistent downward pressure on inflation and upward pressure on unemployment that the Federal Reserve’s monetary policy should, in design and implementation, seek to offset throughout the business cycle and not just in downturns themselves.”
Ever since the FOMC slashed the federal funds rate to a target range of zero to 25 basis points in March in response to pandemic-related lockdowns, it has been pledging “to maintain this target range until it is confident that the economy has weathered recent events and is on track to achieve its maximum employment and price stability goals”.
It will likely reaffirm that pledge this time, but the new framework will give it a more nuanced meaning.
The size of the Fed’s balance sheet is not included in the SEP projections, but Powell and his colleagues have left no doubt they will continue purchasing assets (and make no effort to shrink the balance sheet) and that policy is likely to be reaffirmed on September 16.
So expect the FOMC to reiterate that, “to support the flow of credit to households and businesses, over coming months the Federal Reserve will increase its holdings of Treasury securities and agency residential and commercial mortgage-backed securities at least at the current pace to sustain smooth market functioning, thereby fostering effective transmission of monetary policy to broader financial conditions”.
Certainly, Fed policymakers have been treating the revised policy framework as a touchstone guiding their deliberations in the lead-up to the September meeting.
Thus, Cleveland Federal Reserve Bank President Loretta Mester, an FOMC voter this year, said the new strategy statement “should help clarify and reinforce the FOMC’s policy intentions”.
“We are now clear that after inflation has been running persistently below 2%, not only will we tolerate serendipitous shocks that move inflation above 2%, but that we will likely set policy with the intention to move inflation moderately above 2% for some time,” Mester said. “The new statement language clarifies that in the absence of inflationary pressures or risks to financial stability, strong employment is not a concern and monetary policy will not react to it.”
Mester added, “The completion of the framework review and the revised strategy statement come at an opportune time, in support of the FOMC’s commitment to doing all that it can to support a sustainable recovery back to maximum employment and price stability in service to the public.”
New York Fed President and FOMC Vice Chairman John Williams said changes to the strategy for achieving the Fed’s maximum employment and price stability goals “are mutually reinforcing and will meaningfully improve our ability to achieve both of our dual mandate goals in an environment of a very low neutral rate”.
“The new framework represents both an important evolution in our thinking about how to achieve our goals and another step toward greater transparency,” Williams continued. “Most importantly, it positions us for success in achieving our maximum employment and price stability goals in the future.”
After saying a “highly accommodative monetary policy will be appropriate for some time to come”, Chicago Fed chief Charles Evans, said, “The revised ‘Statement on longer-run goals and monetary policy strategy’ should also help clarify and support our policy goals.”
Fed Governor Lael Brainard also thinks the new framework will make a difference to policymaking in the fairly near term: “The Committee’s new statement on goals and strategy will put us in a stronger position to support a full and timely recovery in employment and average inflation of 2%.”
“With the recovery likely to face COVID-19-related headwinds for some time, in coming months, it will be important for monetary policy to pivot from stabilisation to accommodation,” Brainard continued. “As we move to the next phase of monetary policy, we will be guided by the Committee’s new goals and strategy statement. It will be important to provide the requisite accommodation to achieve maximum employment and average inflation of 2% over time, following persistent underperformance.”
She said, “the new statement puts us in a stronger position to support a full and timely recovery.”
Brainard also maintained that, by enhancing “transparency” in Fed communications to the public and markets, “our new consensus strategy is another important step…in helping us to more effectively achieve our policy goals”.
But the FOMC is not finished. More changes in the way the Fed makes monetary policy are likely coming, and though they may not come at the September meeting, the process will start then.
Clarida hinted at further changes in monetary policy tactics in an August 31 speech, saying, “Finally, now that we have ratified our new statement, the Committee can assess possible refinements to our SEP with the aim of reaching a decision on any potential changes by the end of this year.”
Evans was even more explicit several days later, saying, “These principles are consistent with the type of outcome-based forward guidance that I advocated and that the Committee used to speed the recovery after the Great Financial Crisis, when we were far away from both our inflation and our employment goals.”
“We are in a similar position today,” Evans continued. “And I expect that articulating outcome-based forward guidance for the rate path and asset purchases could be beneficial in the not-too-distant future.”
The FOMC has already discussed resorting to “outcome-based forward guidance”. Minutes of the July meeting disclosed that advocates of revised policy communications “commented on outcome-based forward guidance – under which the Committee would undertake to maintain the current target range for the federal funds rate at least until one or more specified economic outcomes was achieved”. There was also discussion of calendar-based forward guidance.
So it is doubtful whether the FOMC is finished rejiggering policy after an 18-month review.
Alas, the new strategy raises as many questions as it answers. The FOMC has given itself ample latitude, but what will Powell and Co. do with it? We don’t know, and they probably don’t either.
First of all, let’s admit there is plenty of room for criticism of how policy was made in the past.
Seven years after taking the funds rate to zero in the aftermath of the financial crisis, the FOMC began raising the funds rate in December 2015 by 25 basis points and raised it another 200 basis points, bringing it to a target range of 2.25% to 2.50% in December 2018. It had plans to raise it even more, but for untoward developments abroad and muted inflation.
The median projection in December 2018 was 2.9% at the end of 2019 and 3.1% at the end of 2020. Instead, the FOMC took back some of those rate hikes, leaving it at 1.50 to 1.75% before the virus invaded.
A common complaint was that the Fed jacked up the funds rate (and began shrinking its balance sheet) even though inflation persistently undershot its 2% target. It did so because of a compulsion to “normalise” monetary policy and thereby restore some room to manoeuvre against any future crisis and because legacy Keynesian beliefs convinced most policymakers that above potential growth and historically low unemployment must inevitably push up inflation.
President Trump was not alone in condemning these policies, which seemed to make little sense relative to subpar inflation and falling neutral rates.
Now, the Fed is reconciling its monetary policy strategy to those alternate realities, but the new framework doesn’t really explain how the Fed is going to make policy.
The FOMC declares it will continue to be “forward looking”, which means expectations will be as important as ever. but having ditched the Phillips Curve and a specific inflation target how will it set the funds rate? How will it decide the appropriate size of its bond portfolio?
Without target ranges for either unemployment or inflation, one suspects that seat-of-the-pants judgments, perhaps influenced by political pressure, will hold sway as much as ever — maybe more.
If recent encouraging economic trends continue, ultimately bringing the economy back to full employment and if this is accompanied by further asset price inflation, will the Fed make traditional kinds of monetary adjustments or will it feel bound by its new framework to keep rates artificially low waiting for average consumer price inflation to catch up?
Answer: who knows?
For now, the policy approach the FOMC has chosen dictates rock-bottom short-term interest rates as far as the eye can see. And the Fed is not just keeping the federal funds rate near zero. Zero short-term rate policy combined with quantitative easing will be holding down long-term rates as well.
If inflation continues to average below 2%, which is quite plausible in this infectious, globalised economic environment, the Fed may find it difficult to justify moving away from the zero lower bound anytime in the foreseeable future even if unemployment is below recent reconfigured notions of NAIRU. (In the June SEP, the longer run projection for unemployment was 4.1%).
Fine, some might say, but an indefinite stay at zero would be worrisome in a number of respects.
The trap for the Fed and for all of us is that a sustained period of minimal interest rates across the maturity spectrum can only intensify an increasingly desperate “reach for yield”.
We have seen the kind of financial imbalances and disruptions that can lead to asset price bubbles, which some believe are already forming, inevitably burst with severe economic and financial consequences at some point. The recent tech stock correction provides a reminder.
If and when another financial crisis occurs, the Fed will find itself with little recourse. Although the Fed insists it still has tools with which to battle recession, the reality is that its room for manoeuvre is scant.
Brainard conceded the point in her Sept. 1 speech: “With a flat Phillips curve and low inflation, the Committee would have to sustain the federal funds rate below the neutral rate for much longer in order to push inflation back to target sustainably. The resulting expectation of lower-for-longer interest rates, along with sustained high rates of resource utilisation, is conducive to increasing risk appetite, reach-for-yield behaviour, and incentives for leverage – which can boost financial imbalances as an expansion extends.”
“In this way, the combination of a low neutral rate, a flat Phillips curve, and low underlying inflation can lead to more cyclical volatility in asset prices,” she went on. “With financial stability risks more tightly linked to the business cycle, it is vital to use macroprudential as well as standard prudential tools as the first line of defense in order to allow monetary policy to remain focused on achieving maximum employment and 2% average inflation.”
Easier said than done.
That’s not all. If the Fed is going to keep short-term interest rates near zero — and indirectly hold longer term rates below1% — for years on end, in order to achieve an average 2% inflation rate, then it is condemning many millions of people to negative real returns on their savings — an invitation to risky investing and its consequences.
What’s more, the Fed is not just “accommodating” the economy, it is accommodating the voracious appetite of the federal government and others for cheap debt finance.
Intentionally or not, keeping interest rates at extremely low levels not only encourages potentially dangerous private and corporate debt finance, it incentivises reckless federal deficit spending. That may seem a quaint notion at a time when Fed officials are openly calling for more “fiscal stimulus” and Congress is debating whether the next “relief” package should be $1 trillion or $3 trillion, but the news that US debt held by the public is approaching a post-war record 100% of GDP should provide a wake-up call, amid speculation that the dollar’s predominant role is in jeopardy.
Dallas Fed President Robert Kaplan expressed concern about “dollar weakness” when I interviewed him a few weeks ago.
If the dollar does depreciate further, the Fed could find itself coping with a higher inflation average than it reckoned on. Be careful what you wish for!