The story

In a speech in August, Federal Reserve Chair Jerome Powell announced the key outcome of the Federal Open Market Committee’s (FOMC) monetary policy framework review: a flexible form of average inflation targeting (AIT). At the same time, the FOMC released an updated Statement on Longer-Run Goals and Monetary Policy Strategy. The new statement included inflation-friendly revisions to the FOMC’s approach to both its employment and inflation objectives.

The announcement was initially met with skepticism from capital markets, with investors voicing concern about the potential for runaway inflation and a decline in the value of the US dollar.

The reality

In the slow-growth, low-inflation environment in place since the end of the Global Financial Crisis, the Fed’s preemptive approach created uncertainty and equity market volatility.

Over the last ten years, falling unemployment did not lead to inflation

Seasonally adjusted change in “Core” CPI (less food and energy) and unemployment rate as of August 2020. Shading indicates U.S. recession; the most recent is ongoing. Source: US Bureau of Labor Statistics, Federal Reserve Bank of St. Louis.

That preemptive approach encouraged the Fed to raise short-term interest rates when the level of unemployment was sufficiently low that the economy had reached so-called full employment, even if inflation was low and economic growth was slow. The implicit assumption was that the relationship between unemployment and inflation that led to the high inflation the U.S. experienced in the late 1960s and 1970s was more or less intact.

It was a challenge for the Fed to articulate its intentions and beliefs as it began to raise rates in 2016-17 – unemployment was nearing all-time lows—but inflation remained stubbornly below 2%. The real-world downside potential of the communication challenges became evident in early October 2018, when a comment by Fed Chair Powell ignited an equity market sell-off of almost 20%.

Going forward, monetary policy will be informed by the FOMC’s assessment of “shortfalls of employment from its maximum level” rather than “deviations,” the language previously used. This change represents a shift toward an asymmetric response to the employment gap under which an unemployment rate below the estimated natural rate of unemployment is not a sufficient reason on its own to tighten policy. The new statement also now describes the maximum level of employment as a “broad-based and inclusive goal.”

The bottom line

At its meeting in mid-September, the FOMC adopted outcome-based criterion where it expects to maintain the current fed funds target range “until labor market conditions have reached levels consistent with the Committee's assessments of maximum employment and inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time.”

There may be many uncertainties and risks facing the US economy over the next few years, but a premature interest rate hike is not one of them.

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