September 1, 2020
In a major policy shift, the Federal Reserve recently announced it will not raise interest rates to combat incoming inflation just because the unemployment rate is low. While emphasizing the importance of a strong labor market, the chair of the Federal Reserve, Jerome H. Powell, said the Fed will tolerate slightly faster price gains. As a result, this change in policy could result in years of low-interest rates, which in turn, could translate into long periods of cheap mortgages and business loans. These changes were detailed at the Fed’s annual Jackson Hole, Wyoming policy symposium, which took place August 27 and 28, 2020
One of the Fed’s major goals in adjusting its policy is to maximize employment, especially for low and moderate-income families. Although market reaction to this announcement was mixed, many investors had already penciled in years of low-interest rates, and will now wait for more concrete guidance, which is expected to occur soon at upcoming meetings. While the coronavirus pandemic has created a significant threat in the short run by closing businesses and many people losing their jobs, this is not the main reason why the Fed decided to change course. It has recently been acknowledged that price gains have proved to be tepid, even as interest rates have slipped lower in many advanced economies such as the United States.
Although the Fed’s twin goals of maximum employment and maintaining stable inflation have not changed, this “subtle shift” in how these goals may be achieved has proved to be significant. Historically, the Fed has raised interest rates as joblessness has fallen in order to avoid “economic overheating” that may result in breakaway inflation. The Fed has now recently acknowledged that too-low inflation can be just as damaging as high inflation. Simply put, the central bank is no longer planning to raise interest rates to “cool off” the economy because unemployment has declined to low levels. The Fed is trying to convince the public and investors that allowing prices to rise a little bit faster may ultimately not be a bad thing.
While higher inflation may seem like an odd goal for a regular consumer, weak price gains can actually have adverse effects on the economy. When this occurs, there is less room for policymakers to cut rates in order to stimulate the economy. If the Fed can effectively achieve slightly higher priced gains, then there will be more room for future rate cuts, which is a major goal for 2020. Many economists remain skeptical as to whether the Fed can actually achieve this new inflation target, calling the greater than 2% inflation goal “a long way off”. What is known is that many of the changes recently announced by the Fed have been put in motion over the past decade. What remains to be seen is how long it will take or if their goals will ever really become reality.