The Fed’s New Monetary Policy Is Not That New

(Bloomberg Opinion) -- The Federal Reserve’s long-awaited revision of its monetary policy — the fruit of nearly two years’ discussion and reflection — takes a small step at the modest end of the changes the Fed was weighing. This is understandable. Central bankers rightly prize stability and by nature frown on radicalism. In due course, though, the Fed might find it necessary to go further.

Chairman Jerome Powell’s speech Thursday on the subject crisply summarized the difficulties monetary policy has to face in a “new normal” of slower long-term growth and persistently low interest rates. Once the policy rate has fallen to its effective lower bound (zero or perhaps a bit less), it can’t be cut any further, even though the economy might still need a monetary push. Buying bonds on an enormous scale can help, but there are drawbacks. The Fed’s challenge, in effect, becomes one of convincing financial markets that if inflation settles below target, the policy rate will be held low for longer than investors would otherwise have expected.

In the future, Powell explained, the Fed will do this by recasting its 2% inflation target to make clear that it means “inflation that averages 2% over time.” The idea is to convey that overshoots of inflation will be not merely tolerated but aimed for, if they come after periods of less-than-target inflation. Reinforcing this “lower for longer” message is new Fed language on the labor market. From now on, the central bank won’t move to tighten policy as soon as an estimated benchmark of full employment has been achieved; it will wait, instead, for other signs of “unwanted increases in inflation.”

These changes are subtler than they might seem. The Fed has long been at pains to make clear that the 2% target was “symmetric.” Under its previous policy (and in marked contrast to that of the European Central Bank, for instance), the 2% target was not a ceiling, and the Fed always envisaged inflation overshoots under certain circumstances. When it comes to the labor market, successive estimates of full employment were surpassed before the pandemic struck, even as the Fed cut rates to sustain the expansion. In large part, the new statement merely describes existing policy.

To be sure, it makes a difference that from now on the Fed is suggesting that it will actually engineer inflation overshoots after periods of undershoot. (A further implication, by the way, is that the Fed will engineer undershoots to follow overshoots — a politically challenging prospect, though one the central bank doesn’t expect to confront any time soon.) It’s crucial to note, though, that Powell has kept the details extremely vague.

“In seeking to achieve inflation that averages 2% over time, we are not tying ourselves to a particular mathematical formula that defines the average,” he said. “Our decisions about appropriate monetary policy will continue to reflect a broad array of considerations and will not be dictated by any formula.” In other words, the Fed’s new target of “average inflation” is actually unstated. Exactly what it means, and how it differs (if at all) from policy to this point, remains to be seen. While retaining needed flexibility, this vagueness will diminish the effect of the change on future expectations — a trade-off that’s inescapable in monetary policy.

In fact, it’s quite possible that the new regime, when tested, will only add to investors’ confusion about the Fed’s intentions. Consider this remark from Powell’s speech: “Following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.” (Emphasis added.) After periods of too-low inflation, Fed policy might deliver stronger stimulus than you were expecting, or it might not.

There are firmer ways of promising “lower for longer.” In addition to announcing an explicit formula for average inflation targeting, the possibilities include adopting a higher target for inflation (4%, say, rather than 2%). Many economists favor recasting the target in terms of nominal gross domestic product (which would automatically tolerate inflation above 2% if output were growing too slowly). Some argue that negative interest rates would be the best way to deliver monetary stimulus when the prevailing rate is at or close to zero; most are leery of the practical difficulties.

For the moment, there’s no clear answer — except to note that under current circumstances the power of monetary policy is diminished and fiscal policy needs to play a much bigger role. It suffices to say that this won’t be the last of the Fed’s monetary policy reviews, and you haven’t heard the last of those other possibilities.

Editorials are written by the Bloomberg Opinion editorial board.

©2020 Bloomberg L.P.