The Fed’s Change in Monetary Policy is Important for a Sustainable Recovery
After Paul Volcker successfully brought inflation under control in the 1980s, the Fed’s credibility had been restored. The public felt confident that after such a hard-fought victory, the Fed could be counted on to keep inflation under control. That credibility was subsequently enhanced by the formal adoption of a 2 percent inflation target under Ben Bernanke. Along with the assumption that the neutral rate of unemployment was in the vicinity of 4.5-4.0 percent, investors and consumers believed that monetary policy would begin to tighten as economic conditions resulted in these targets coming into focus.
But to a certain extent, the Fed became a victim of its own success. In the wake of the financial crisis, this inflation fighting confidence began to have a chilling effect on economic activity, despite interest rates having been lowered to the zero bound and large-scale quantitative easing having been deployed. There was an underlying skepticism that these exceedingly accommodative, non-traditional policies would be maintained long enough for risk taking to be rewarding. As a consequence, growth during the recovery from the financial crisis was slower than expected, or hoped for, and inflation persistently fell short of the Fed’s target. Other factors were at work as well, including slowing productivity growth and declining potential output.
In addition to stimulating growth, the Fed also wanted to push inflation and interest rates higher since rates effectively at zero left little room for monetary policy to be stimulative in an economic downturn. The Fed would very much prefer a slightly higher inflationary environment that allows it to raise the overnight rate to its longer-run presumed neutral rate of 2.5 percent. Frustratingly, neither growth nor prices have responded sufficiently to create such an environment.
The Fed’s Monetary Policy Will be More Accommodative Going Forward
Last week, after a thorough review, the Fed announced a change in its approach. The intent is to convince the public that monetary policy will not automatically begin to tighten as inflation approaches the 2 percent target and unemployment falls below its presumed neutral rate. While the 2 percent inflation target remains, the Fed is now willing to allow inflation to rise above the 2 percent level for some time to compensate for the time it spends below it. Going forward, the 2 percent target will be thought of as a desired average over time. As for unemployment, before the pandemic the rate of unemployment had fallen to a fifty-year low of 3.5 percent without applying any appreciable upward pressure on inflation, leading the Fed to conclude it could be less proscriptive in its view of what is a tolerable rate of unemployment.
The New Framework is Not a Cure-All, but it is Important to a Sustainable Recovery
For such a framework change to be convincing, the public must believe that it represents a commitment by the Fed, and not just a general proposition. Importantly, the Fed chose to signal its intention to leave the overnight rate at its current 0.00-0.25 percent range through 2022 at its June meeting, despite its median projection that core inflation would rise to 1.7 percent from its expected rate of 1.0 percent this year. Of course, the Fed’s new framework does not preclude it from tightening policy if inflationary pressures rise sufficiently to warrant such action. But what it does do is remove the more formulaic expectation of the Fed’s inflation reaction function. In practical terms, unless inflation rises above 2 percent to a problematic extent, policy will remain exceedingly accommodative, with the intent of making risk taking more rewarding, resulting in firmer economic activity. How successful the new framework is in raising inflation over time will dictate when monetary policy becomes less accommodative.
Lower for longer interest rates should provide a tailwind for risk assets. For policy to be consistent, the Fed’s balance sheet must continue to grow as well. But by itself, this new framework is no panacea. The global economy is still dealing with the pandemic. And the pace of recovery remains uncertain. But a commitment by the Federal Reserve to remain exceedingly accommodative for longer is an important component of a sustainable recovery.
Sources: Factset, Bloomberg. FactSet and Bloomberg are independent investment research companies that compile and provide financial data and analytics to firms and investment professionals such as Ameriprise Financial and its analysts. They are not affiliated with Ameriprise Financial, Inc.
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