The Federal Reserve’s New Strategy Comes With Major Risks

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After a more than year-long review of its monetary policy strategy, the Federal Reserve has decided it will throw away the rule book and let inflation run higher and unemployment run lower before seeking to tighten financial conditions. To be clear, this change leaves the central bank pursuing an almost completely discretionary monetary policy, one where the risk is that the Fed fosters a more uncertain policy environment.

The Fed didn’t add any substance to their updated strategy – hopefully that will come later - leaving market participants somewhat adrift with respect to exactly what policy makers are trying to achieve. This lack of clarity may have been behind the rise in bond yields Thursday. It is reasonable to think yields will continue to drift higher until the Fed clarifies its intentions.

Policy makers have long been moving in the direction of more discretion. The old rules-based approach governing when to tighten and loosen monetary policy has fallen into disfavor as those rules were proven to be unreliable in times when economic conditions swiftly changed. In retrospect, a reliance on guides such the Taylor rule (which relates policy rates to output and inflation gaps) and the Phillips Curve (which relates inflation to unemployment rates) caused the Fed to over-predict inflation and set interest rates too high in 2018.

Even if the Fed could not rely on the old economic rules to guide policy, that guidance was still directed at sparking inflation toward the Fed’s 2% target. First implemented in 2012, the target still gave a sense of where the Fed wanted to go even if changing economic fundamentals made it less certain of how to get there. That changed Thursday, with Fed Chair Jerome Powell signaling that the central bank will tolerate an inflation rate above its 2% target by an unspecified magnitude for an unspecified period of time before tightening monetary policy. Not only is the economy adrift without policy rules, the Fed’s ultimate goal is no longer certain because it’s unclear what happens and when if inflation rises above the central bank’s target.

More specifically, the Fed formally adopted an average inflation targeting strategy in which it attempts to foster above target inflation to compensate of periods of below target inflation. Sounds straightforward, but the Fed made no shortage of caveats to the strategy:

In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

Consider all the modifiers in that sentence, “likely,” “moderately,” and “some.” There is a lot of wiggle room there. Consider also Powell’s further explanation:

In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average. Thus, our approach could be viewed as a flexible form of average inflation targeting.

While the Fed moved policy in a dovish direction, it is also brought more uncertainty about the ultimate goal. Without a formula to define the average, the Fed’s interpretation of average is subject to change. We don’t really know the Fed’s goal for the inflation rate in either the near or medium term, nor do we know the timeline or what if anything the Fed is willing to do to achieve that goal. And while we know the Fed is willing to allow inflation to drift higher, we have no sense of how much higher and for how long. Will the Fed proactively try to spur inflation higher? Or does it intend an entirely passive strategy? Does intend to allow longer term bond yields to continue their upward drift? Was this their intention when the put yield curve control on the back burner

To be sure, this lurch toward discretionary monetary policy is not entirely unwelcome. As the Fed learned during the last cycle, a shifting economic landscape means it can’t be straightjacketed into a policy path. But the new discretion creates uncertainty for market participants because of all the unanswered questions. The Fed doesn’t seem ready to provide answers, as the minutes of the last Fed meeting in late July revealed it was in no rush to adopt enhanced forward guidance. That may change as policy makers build on the strategy update.

In a sense, the Fed has unanchored policy expectations by creating uncertainty around what it means to meet its inflation target. Economists and market participants are adrift until further guidance is provided. The result will potentially be disruptive. For example, I believe the Fed ultimately does not want bond yields to climb. If accurate, that risks a sharp reversal lower in yields when the Fed makes their policy intentions clear.

The Fed’s shift toward greater discretion may improve economic outcomes but it comes with the risk of more communication missteps such as experienced with the 2013 “taper tantrum.” The release of the updated strategy without additional policy guidance may have been the first misstep. 

This column does not necessarily reflect the opinion of the editorial board or Bloomberg LP and its owners.

Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.

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