Will the Fed’s recasting of its monetary policy strategy help the US economy?

The Federal Reserve has decided to recast its monetary policy strategy — replacing a longer run 2 percent inflation target with an average inflation targeting framework. According to Chairman Jerome Powell, the Fed will henceforth “seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” This has been widely interpreted as a signal by the U.S. central bank that it will take a more dovish stance on inflation and instead aggressively pursue its other mandate, achieving full employment. In practical terms, the implications are that the Fed will no longer pre-emptively raise rates at the first sight of inflationary pressures, and that it will keep policy rates lower for longer to aid labor market recovery.

Despite engaging in a lengthy review process, the Fed appears to have failed to adequately address several areas of concern. First, the appropriateness of trying to target (on an average basis or otherwise) a specific inflation rate was not given due consideration. Prior to the pandemic, there was some handwringing over the fact that the central bank had consistently undershot its 2 percent inflation target. As former Chairman Paul Volcker and others have noted, there is nothing magical about the 2 percent inflation target. (In fact, its origins lie in the Reserve Bank of New Zealand’s early adoption and pursuit of an inflation target.)

All major price indices have their own set of inaccuracies and biases, which makes it impossible to precisely capture actual changes in consumer price levels. Given the inherent difficulties associated with measuring inflation, it is unclear what, if any, damages will be sustained by the real economy if average price levels rose by, say, 1.75 percent instead of 2 percent. As the Fed gets set to embark on its new path, central bankers need to be mindful of the warning issued by Volcker: “The real danger comes from encouraging or inadvertently tolerating rising inflation and its close cousin of extreme speculation and risk taking, in effect standing by while bubbles and excesses threaten financial markets. Ironically, the ‘easy money,’ striving for a ‘little inflation’ as a means of forestalling deflation, could, in the end, be what brings it about.” 

Another area of concern relates to financial market distortions arising from central bank actions. The new monetary framework fails to explicitly incorporate financial stability into the central bank’s reaction function. It can be argued that monetary policy since 2008 has aided and abetted financial risk taking and contributed to a surge in asset prices and corporate debt levels.

Following the collapse of Lehman Brothers, the Fed kept the federal funds rate target near zero for seven years. With nominal policy rates stuck near the zero-lower bound, the Fed decided to pursue large-scale asset purchase programs (LSAPs) and engaged in forward guidance. Three rounds of LSAPs (also referred to as quantitative easing), undertaken between 2009 and 2014, saw the Fed’s balance sheet increase by over $2.5 trillion (a five-fold increase between 2007 and 2014). Asset purchases by the Fed and the promise to keep rates lower for longer (referred to as “forward guidance”) provided a fillip to risky financial assets as investors sought higher yields. 

Furthermore, asymmetric monetary policymaking by the U.S. central bank since the Greenspan era has created the impression among the investor class that there exists a “Fed put” that reduces risk for equity investors. The Fed has shown a willingness to implicitly aid financial markets by providing monetary relief in response to any sharp dips in equity prices while pursuing a policy of tolerance for asset bubbles. The 2018-2019 period provides a telling illustration — the Fed’s brief dalliance with monetary policy normalization ended abruptly when stock markets underwent a sharp correction in December 2018; and, the central bank turned suddenly dovish and engaged in three rate cuts in the second half of 2019.

Finally, the new monetary policy strategy fails to fully acknowledge the factors influencing inflation dynamics that are beyond the Fed’s control. A fundamental flaw of post-2008 monetary policy is the failure among central bankers to realize that their quest to reach the 2 percent inflation target, when faced with major structurally disinflationary forces, was rather quixotic. Trapped by an almost mythical belief in the significance of anchoring inflation expectations, the Fed has for the most part underappreciated the role of structural forces (demographics, technological changes, globalization and the decline in the bargaining power of labor vis-à-vis capital) that were keeping a lid on measured inflation over the past decade.

In response to the pandemic, the Fed initially provided much needed relief to credit markets by acting as a “lender of last resort” and by providing emergency liquidity. Even after credit markets stabilized, the Fed has sustained an aggressive stance and undertaken record levels of asset purchases (the balance sheet rose by nearly $3 trillion over the past six months) to provide economic relief. It is, however, unclear how such actions are going to aid an economy dealing with a health crisis.

Financial market distortions, new asset bubbles and worsening of the wealth gap may be the ultimate result of the Fed’s well-intentioned but misguided policy actions. More generally, a downside of the Fed’s aggressive actions is that it has often let fiscal authorities off the hook and prevented implementation of some much-needed structural reforms.

Vivekanand Jayakumar is an associate professor of economics at the University of Tampa.