(Bloomberg Opinion) -- The U.S. Federal Reserve is changing the way it conducts monetary policy, a move that will have significant long-term consequences for interest rates, inflation and employment. But, unfortunately, this shift is not likely to be of much help to the current, fragile recovery.
Last week, Fed Chair Jerome Powell announced two important revisions to the central bank’s long-term monetary-policy framework. First, the central bank will try to achieve “inflation that averages 2 percent over time” — which means it will allow inflation to rise (or fall) above (or below) 2% based on where inflation has been and for how long. Second, the Fed will put more emphasis on keeping unemployment low: Instead of aiming to minimize “deviations” from the maximum sustainable level consistent with stable inflation, it will seek to minimize “shortfalls of employment from its maximum level.”
There are good reasons for the Fed to make these changes. For one, persistent low inflation has pulled expectations of future inflation below 2%. This effectively increases inflation-adjusted interest rates, which tightens monetary policy and makes people and businesses less likely to borrow and spend. If this dynamic were to continue, the U.S. could conceivably end up in a Japan-like “liquidity trap” in which the Fed became powerless to achieve its monetary policy objectives.
Also, the robust job growth of the last expansion, which pushed the joblessness rate as low as 3.5%, didn’t push up wages and consumer prices as much as anticipated. This led economists to conclude that the Phillips curve, which describes the relationship between unemployment and inflation, had flattened — that is, a tight labor market resulted in less inflation than previously. This has encouraged the Fed to put greater emphasis on its employment objective.
In practice, the new regime means that the Fed will generally be slower to tighten monetary policy in order to ensure that inflation climbs above 2% and stays above 2% for a time to compensate for past, downside misses. The key metric to focus on is inflation expectations: The Fed will conduct monetary policy with the aim of keeping them anchored at 2%. If they persist in being too low, actual inflation might have to overshoot for longer to get them back up; if, instead, they return quickly to 2%, then the Fed may not have to fully offset all the past misses. So the actual average inflation rate can deviate a bit from 2% if that is what is needed to keep inflation expectations at 2%.
When the central bank does tighten, it will need to push the unemployment rate up to keep inflation under control. This means the Fed will likely raise interest rates faster and higher. The good news is that higher interest rate peaks will give the Fed more firepower to fight future recessions. The bad news is that the need for sufficient tightening to push up the unemployment rate will increase the risk of recession.
Will the new regime be an improvement? Yes, but the Fed has been unable to hit its 2% inflation target for a decade. Why, then, should one believe that it can do any better achieving a 2% average? This is especially relevant at time when the power of additional monetary policy easing to stimulate the economy has clearly diminished. After all, interest rates are already extremely low and financial conditions are easy. More of the same won’t do much to bolster economic activity.
The Fed’s new policies are sensible, and will be helpful down the road in keeping inflation expectations well-anchored. But the new regime won’t do much now to support household and business income. For that, Americans need to look elsewhere — specifically, to Congress and the White House for further fiscal stimulus.
This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.
Bill Dudley is a senior research scholar at Princeton University’s Center for Economic Policy Studies. He served as president of the Federal Reserve Bank of New York from 2009 to 2018, and as vice chairman of the Federal Open Market Committee. He was previously chief U.S. economist at Goldman Sachs.
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