Federal Reserve shifts the goalposts – what does this mean for inflation?

The Federal Reserve (Fed), America’s central bank, has changed its policy goals. The changes seem subtle, but may prove to be important going forward.

We’ll explain what the Fed has changed and what this could mean for inflation.

The Fed is given its instructions by Congress in the form of the Federal Reserve Act, and as such is tasked with conducting monetary policy “so as to promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates.”

There are several parts to this, and we’ll start with stable prices.

Stable Prices

Inflation is the general rise in price of the things we spend money on every day. In the past the Fed interpreted “stable prices” to mean annual inflation of 2% over the longer run.

The Fed is now targeting “inflation that averages 2 percent over time”.

This means that after periods of low inflation, like the US has experienced for the past few years, the Fed will allow inflation to go over 2% in the future. It suggests interest rates will be kept low to support the economy, even if inflation starts to rise.

Maximum Employment

The Fed has also changed its goals for maximum employment. The Fed will now alter its policy when it observes “shortfalls” from maximum employment, instead of “deviations”.

To explain why this matters we need a short refresher on monetary economics. Bear with me.

The idea is that as unemployment falls businesses have to raise wages to attract workers. Rising wages mean people have more money to spend, so people start bidding up prices and inflation sets in.

Central banks would therefore keep a close eye on the unemployment rate, and might raise interest rates if it fell too far – on the grounds that inflation was right around the corner.

By raising interest rates a central bank could control inflation, which is good, but would also tend to increase unemployment, which is bad.

However, we’ve recently experienced a long period of economic growth and very low unemployment compared with history. Yet inflation has been nowhere to be seen.

Going forwards the Fed will no longer pre-emptively raise interest rates if unemployment falls below its historical levels.

Chart showing levels of unemployment and inflation

Source: Federal Reserve Bank of St. Louis, 28/08/20.

What does this mean for inflation?

The Fed has essentially relaxed its goals to become more tolerant of inflation in the future. However, inflation has remained stubbornly low for years now, and we doubt this change in approach will change that.

It’s an open question whether we’ll see inflation in the near future, and there are good arguments on both sides.

On the one hand, central banks are keeping interest rates low and engaging in massive quantitative easing programs, and governments are spending heavily.

On the other hand, unemployment is high and pandemic-induced disruption may have reduced demand for some goods and services.

On balance we think inflation is probably unlikely in the near term, but may pick up later on.

If it sounds like we’re unsure, it’s because we are. As US President Harry Truman once quipped, “give me a one-handed economist”!

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