FED’s New Monetary Framework 2020

Source: Bloomberg

In Federal Reserve’s annual policy symposium traditionally held in Jackson Hole, Federal Reserve Chair Jerome Powell announced the new monetary framework that focuses on allowing inflation and employment run higher in a shift that will likely keep interest rates low for years to come. Firstly, the Fed will adopt a Flexible Average Inflation Targeting (FAIT) that seeks inflation of an average of 2% over time, permitting for price pressures to overshoot after periods of weakness. Secondly, the Fed has also decided to treat unemployment as “shortfalls of employment from its maximum level” instead of “deviations from its maximum level.” Moreover, it will act when inflation hits on an average of 2% instead of pre-emptively adjust rates based on Fed’s inflation expectation. Thirdly, the Fed adjusted its view of employment to allow a more comprehensive labour-market gains to reach more workers especially those at the lower income strata. Lastly, Fed officials also altered the strategy document to include a section acknowledging that financial stability can also affect their ability to reach their long-run goals (Torres, Condon, & Matthews, 2020).

Avoid Negative Interest Rate and Stagflation

Aligned with other critics, I believe that the new monetary framework is Fed’s attempt to manage expectations in order to avoid a negative interest rate and avoid a situation that is akin to Japan’s stagflation. Therefore, it is important that inflation rate remains robust in order to keep real rates low and avoid needing the Fed to explore negative interest rates that many European nations and Japan have done. Stagflation and negative interest rates can potentially make economic downturns deeper and longer. Ideally, businesses and individuals would anticipate higher inflation in the future and incorporate this into their investments, pricing and wage decisions. It then becomes a self-fulfilling prophecy for inflation to pick up.

It is Vague and Imprecise

The common consensus is that the idea of an average inflation targeting is vague. In my opinion, the Fed has purposefully left it vague to allow more room for the Fed to respond and accommodate to prevailing economic circumstances. Like a balancing act, the Fed has to strike a balance between inflation and maximum employment. But what we know is the Fed might be willing to accept slightly higher inflation that is beyond 2% without increasing interest rates if the economy is closed to full-employment. Nevertheless, price stability remains the overriding goal for the Fed.

The new monetary framework is an attempt to move away from conventional view of a pseudo and allusive “maximum” employment level but move towards a goal that focuses on making up shortfalls. The widely accepted Keynesian economics has long postulated that unemployment and economic recession is a “deviation” from maximum employment to explain short-term fluctuations of output. The New Keynesian Philip Curve that states inflation is dependent on two factors inflation expectation and output gap of the economy. Due to the economic recession and a potential for prolonged weakness in aggregate demand, output gap may exist for a period of time even after the pandemic is over. As the economy recovers and move towards maximum employment level, the economy will have to accept higher inflation levels. The inflation averaging policy is thus about accepting slightly higher inflation in order to provide room for any output gap to be closed. If interest rate is risen once inflation runs above 2%, it could come at a cost on the economy in terms of output. This is also covered by the IS curve , that states a negative relationship between policy rate and output.

Historical Inflation Rate in the Past Decade

Figure 1: U.S. Historical Inflation Trend 2010 to 2019 (Torres, Condon, & Matthews, 2020)

However, I do share the doubts of many on the FED’s inability to hit the inflation target. The new framework mainly acts as a contingency plan for situation when inflation rate do indeed run beyond the 2% level. I believe inflation will not be a major concern for at least in the next few years given the structural impacts that Covid-19 have caused and weakness in the consumption side of the economy. In the past decade, since the 2008 Financial Crisis, inflation has been muted and fell short of the 2% level for most periods (Figure 1) with an experience of a very low level of unemployment (a flatter Philips curve). Nonetheless, there are other potential risks such as supply-side constraints caused by Covid-19 that could cause inflation to pick up. On the other hand, the Fed should be more cognizant of the fact that inflation is very much hidden in investment assets which has been seen as inflation of asset prices. This is largely a result of massive, expanded quantitative easing that the Fed has committed. Money channelled into asset markets has limited overall stimulating impact on the real economy.

Inclusivity and Diversity

I applaud the broader and more inclusive definition of maximum employment that includes diverse communities especially low-income individuals. There has been widespread criticism that quantitative easing only benefits the rich (Luke Rawlings, 2020). Although not something of a major move but I believe it is a step in the right direction to express their desire for more inclusive growth and monetary policies.

Limitation of Monetary Policy

The Fed understands their limitations. Jerome Powell has expressed his fear that US could face tragic risk from doing too little fiscal support for the economy (Timiraos, 2020). In my opinion, the Fed has done a great job in maintaining financial stability and providing liquidity to both wall street and main street in times of the current crisis. However, there is a desperate need for more fiscal policy which will have a greater impact in pushing inflation and providing more support for employment. Therefore, the new monetary policy could accommodate the effects of a large fiscal stimulus.

Implications for Asian Economies

Singapore’s Garden by the Bay with Keppel Bay in the Backdrop

The Singapore economy adopts a floating interest rate policy with rates predominately trending with the U.S. interest rates. The new monetary policy framework indicates that Singapore’s interest rates will remain low for the years to come. On the other hand, whenever interest rate remains low in developed countries, capital tends to flow towards developing countries in the region where yields are higher. Furthermore, the low dollar interest rate would also have a depreciating impact on the greenback prompting investors to invest in equities and fixed income of countries with currencies that would appreciate against the U.S. dollar.

Asset and Debt Bubble

A period of low interest rate also brings about concern of deleveraging in post-pandemic world as businesses take up huge amounts of debts during the economic crisis. I am glad the Fed included a section acknowledging that financial stability can also affect their ability to reach their long-run goals. As important as it is for the Fed to prioritise on price stability and employment, financial stability of the markets is arguably equally important. If not well-managed, an economic crisis can easily turn into a financial crisis especially when default rates rise. I am in support that the Fed should continue its pursue of supporting a well-functioning market, alongside the other goals it has.

In conclusion, the new monetary policy framework provides the Fed more flexibility in managing their dual mandate and possible trade-offs between the two, and provide reassurance that rates will remain low even as the economy recovers.

Luke Rawlings(2020, November 11). Quantitative Easing in a Covid-19 Economy: How the Rich got Richer. Retrieved November 28, 2020, from https://www.internationalaffairshouse.org/quantitative-easing-in-a-covid-19-economy-how-the-rich-got-richer/

Timiraos, N. (2020, October 06). Fed’s Powell Says U.S. Faces ‘Tragic’ Risks From Doing Too Little to Support Economy. Retrieved November 28, 2020, from https://www.wsj.com/articles/feds-powell-says-u-s-faces-tragic-risks-from-doing-too-little-to-support-economy-11601995201

Torres, C., Condon, C., & Matthews, S. (2020, August 27). Fed Paves Way for Low-Rate Era With Inflation Able to Run Higher. Retrieved November 28, 2020, from https://www.bloomberg.com/news/articles/2020-08-27/powell-says-fed-to-seek-inflation-that-averages-2-over-time?sref=vePaFvnA

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