Why the Fed Has a New Framework and Why It Matters

(Bloomberg) -- In August 2020, the U.S. Federal Reserve rolled out a new approach to monetary policy. At the time, the U.S. economy was reeling from the coronavirus pandemic and the Fed was still focused on its aggressive response to that collapse. But the new framework has taken on greater importance as growth has returned. Under the new strategy, the labor market will be allowed to run hotter, and that could help lower-income workers and members of minority groups who sometimes haven’t fully benefited from periods of economic growth.

1. What did the Fed do?

The Fed’s job is to manage the economy to produce both price stability and full employment; its main tool is an interest rate it raises to slow economic activity and lowers to stimulate it. It made changes in the framework it uses to judge when to take action in response to both inflation and labor market trends.

2. Why did it need a new framework?

Long before the pandemic, the Fed decided it wanted to learn from difficulties it had encountered during the last recovery. It had never managed to bring inflation consistently up to 2% since making that its target in 2012, and its employment projections had been wrong time and again.

3. What’s it doing on inflation?

It will now pursue an “average” 2% rate, meaning it will let inflation overshoot the target during a recovery to make up for periods below 2% during a downturn. That is, it will tolerate somewhat higher inflation for a while to make sure that annual gains settle around 2% over time.

4. How about employment?

The Fed is jettisoning its practice of raising rates as soon as its forecasts suggest that the labor market is headed toward overheating — that growing demand for workers could spark inflation by driving up wages. Instead, it says it will let unemployment continue to fall so long as inflation remains low, and will assess the labor market in terms of “shortfalls” from full employment.

5. What does that mean?

The Fed’s success in conquering the double digit inflation of the late 1970s created a legacy that Fed chairs sought to protect. Labor advocates have long argued that in doing so, it has neglected its mandate to promote job creation, and in many ways the Fed is agreeing. Its policies kept inflation subdued but cost working Americans the higher wages and better employment opportunities that would have come from decades of stronger growth. The Fed is now also recognizing that its actions cost Black and Hispanic Americans even more dearly.

6. How’s that?

As part of its new framework, the Fed describes full employment as a “broadbased and inclusive goal.” That’s shorthand for looking not just at the aggregate unemployment rate but at labor-market indicators for different segments of the population, including Black unemployment. In contrast, the Fed, using its traditional approach, raised interest rates in December 2015 for the first time since the 2008 financial crisis, in part because the overall unemployment rate was 5%, close to where the Fed had its estimate of full employment, 4.9%. But Black unemployment was 8.5%, according to revised data. Taking that gap into consideration could help reduce racial inequality.

7. What’s the reaction been?

There’s been no end of questions, and not just in the U.S. — the interest rate decisions of the Fed ripple around the globe. Some of the questions have to do with the wiggle room, or discretion, that Fed officials have left themselves. Instead of laying out quantitative metrics on inflation, for instance, the new policy states that inflation will be allowed to overshoot 2% “for some time.” Second, a post-pandemic boom — fueled by unprecedented stimulus from both the Fed and Congress — is pushing prices up for all kinds of goods and services. Bond investors wonder if inflation might take on a life of its own.

8. How has the Fed responded?

Fed Chair Jerome Powell repeatedly described the signs of inflation as transitory, tied to supply bottlenecks that are temporary, and points to the millions of workers who remain out of a job. Powell and other Fed leaders have shown total commitment to the framework despite the data swings and a certain amount of financial-market volatility. They’re also on guard against the mistake they made in 2015 — tightening too early, before labor market gains reached lower-income workers. The Black unemployment rate in May 2021 was 9.1%, down from a pandemic peak of 16.7% but still well above a pre-pandemic low of 5.2%, let alone the White pre-pandemic low of 3%.

The Reference Shelf

• The Fed in August 2020 published a statement on its new framework, an overview of the review that produced it and a guide to the monetary policy changes it was making.
• Powell discussed the framework at a symposium when it was introduced, and Vice Chair Richard Clarida delivered a speech on it shortly thereafter.
• The Federal Reserve Bank of St. Louis published this analysis of the new monetary policy strategy.
• A column in the Financial Times by Mohamed el-Erian on the Fed’s shift from a “forecast-based” to an “outcomes-based” approach.
• Articles by Bloomberg News on the Fed’s announcement of its new framework, and on the three messages Powell wants the bond market to hear.

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