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Monetary Policy Framework: The Fed Says What, But Needs Help on How

The Federal Reserve released the results of its multiyear framework review alongside a speech by Fed Chair Jerome Powell at the Kansas City Fed’s Economic Policy Forum on 27-28 August. While the announcement came earlier than anticipated, the conclusions were in line with the evolutionary, not revolutionary, changes to the Fed’s framework we have long been expecting.

The Fed’s revised “Statement on Longer-Run Goals and Monetary Policy Strategy” revealed the central bank’s preference to average 2% inflation over time, but stopped short of implementing a new inflation-targeting rule or preferring anything more than a “modest” overshoot of the inflation target. (The Fed’s preferred inflation measure is the core PCE (personal consumption expenditures) deflator.)

The other key conclusion from the framework review was an emphasis of the benefits of allowing the labor market to reach maximum employment, made official in the statement via a switch to an asymmetric unemployment objective.

We view the framework review results – and the forward guidance that we expect to follow soon – as confirming what we already believed about the Fed’s desire to overshoot 2% inflation in order to correct for past inflation shortfalls. It’s not a significant paradigm shift. Given the modest changes in the monetary framework and interest rates at the zero lower bound, the key question is whether these adjustments will be sufficient to engineer the inflation overshoot the Fed desires. With today’s high level of slack in the economy expected to dissipate only gradually, we think fiscal policy, not monetary policy, will be the key determinant of the Fed’s success in reaching its inflation objective over the next several years.

Evolution, not revolution, on monetary policy framework
As expected, the Fed explicitly announced a desire for inflation to “average” 2%, but stopped short of implementing a formal average inflation targeting rule. The Fed further softened its guidance by clarifying that it would target inflation “moderately” above 2%. In addition to confirming rates will remain on hold until inflation rises, the more flexible approach will also allow Fed officials to look through higher-than-expected inflation as needed should it materialize. While the framework review released on 27 August is focused on the longer term, it also sets the stage for the Fed to provide forward guidance about the path of the fed funds rate as early as the September FOMC (Federal Open Market Committee) meeting, where we expect the Fed to announce outcome-based forward guidance tied to this new average inflation objective. We continue to believe the formal introduction of new forward guidance will simply codify what we’ve already learned from Chair Powell’s recent press conferences, as well as what is already priced into markets.

The other significant change in the policy framework is a shift to an asymmetric unemployment objective. The statement now addresses “shortfalls” of unemployment, as opposed to “deviations” in the prior language, but suggests the Fed would tolerate, or even welcome, the return to an unemployment rate below the Fed’s estimate of the level of NAIRU (the non-accelerating inflation rate of unemployment). In the Q&A following his speech on Thursday, Chair Powell noted that the Fed did not hesitate to cut rates in 2019 even though its estimates suggested that unemployment was already below NAIRU.

This change likely reflects two things the Fed has learned over the last several years. First, in his 2018 Jackson Hole speech, Chair Powell noted the considerable uncertainty about what NAIRU (or “u star”) is. Indeed, in the last several years of the U.S. economic expansion, FOMC members consistently revised lower their own estimates of NAIRU. Second, a major conclusion from the “Fed Listens” events that were incorporated into the framework review was that stronger labor markets can have powerful benefits for the labor force, increasing labor supply and reducing inequality. Given that the COVID-19-related economic shock has disproportionally hurt low-income individuals, this conclusion is particularly relevant today – indeed, we’ve seen members of Congress increasingly interested in a more inclusive approach to the Fed’s maximum employment objective.

We also note that the framework review conclusions lack any discussion of the tools the Fed has available to achieve its dual mandate objectives. We had expected that the Fed would use this review to confirm its available tools, that is, to make standard (or conventional) those tools considered unconventional after the financial crisis, such as asset purchases.

Instead, the Fed seems comfortable with the detail provided at recent FOMC meetings for now. Given markets are already pricing in a fed funds rate at the zero lower bound for several years ahead, the use of these additional policy tools is likely to have more market implications than forward guidance on interest rates. We still expect the Fed eventually will provide guidance that asset purchases are being used to support easy financial conditions, and we see room for the Fed to extend the duration of U.S. Treasury purchases should downside risks materialize and more monetary policy support become necessary (for details, see PIMCO’s recent blog post, “Fed Reinforces Commitment to Ongoing Monetary Policy Support”).

Fiscal policy needed to reach monetary policy objectives
Given these evolutionary changes to the approach, the obvious question is if this shift will be sufficient to see the Fed achieve its desired inflation outcome. The initial market reaction to Chair Powell’s speech suggests investors are skeptical. Given PIMCO’s forecast for U.S. inflation to weaken somewhat further given high unemployment, we also don’t expect inflation to return to target in the near term (for details, see our recent blog post, “A Slow and Uneven Recovery Still Likely Despite July’s U.S. Price Bounce”).

However, in the longer run we see potential for the Fed to finally achieve its desired inflation outcome. Over the long term, monetary and fiscal policy will likely be the key determinants of inflation. With interest rates at the zero lower bound and the U.S. federal balance sheet over $7 trillion, monetary policy has limited scope to provide further support, and we see additional fiscal spending (or lack thereof) as the critical determinant of the trajectory for inflation. Fed officials, including Chair Powell, seem to recognize the limits of monetary policy acting alone and have been increasingly vocal over the past several months about the need for fiscal policymakers to provide additional support to the economy.

Bottom line
While the timing of the framework review was earlier than we expected, the evolution of the Fed’s monetary policy framework to prefer an inflation overshoot and asymmetric labor market objective were not. With slack in the economy weighing on inflation and markets already pricing in highly accommodative policy, Fed officials will need help from fiscal policymakers to achieve the average inflation goal outlined in their new framework.
Source: By Allison Boxer, Economist, and Joachim Fels, Global Economic Advisor, PIMCO

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