Fed formally adopts new approach to balance inflation, unemployment

The Federal Reserve on Thursday formally adopted a monetary policy strategy that calls for allowing inflation to run above the bank’s 2 percent target in a bid to maximize the job gains that come with economic expansions.

In a Thursday speech, Fed Chairman Jerome Powell announced that the central bank would aim to keep price and wages increases at an annual average of 2 percent instead of aiming directly at that target. The Fed’s new strategy will likely mean the central bank will tolerate higher levels of inflation for longer stretches to balance out years of persistently low price and wage increases.

“Because the economy is always evolving, the FOMC’s strategy for achieving its goals — our policy framework — must adapt to meet the new challenges that arise,” Powell said, referring to the Fed’s policymaking Federal Open Market Committee.

“The persistent undershoot of inflation from our 2 percent longer-run objective is a cause for concern,” he added.

Controlling inflation — the rate at which prices and wages increase — has been a vexing problem for the Fed for nearly four decades. 

While rapid inflation can pose major risks, economists consider a moderate level of price and wage increases to bring broader economic growth and prosperity in the process. Persistent levels of low inflation can also force the Fed to keep its baseline interest rate range closer to zero percent, which limits its ability to stimulate the economy during downturns.

“We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome,” Powell said on Thursday. “We want to do what we can to prevent such a dynamic from happening here.”

The Fed announced in November 2018 it would review its approach to inflation as the steady decline of the unemployment rate failed to drive the rate of price and wage increases to the bank’s target. The bank began a series of listening sessions across the country, focusing on how the steady decline of the unemployment rate below 5 percent — which the Fed thought would spur inflation — improved the lives of the most vulnerable communities.

Powell said Thursday that the Fed concluded its review with four key takeaways: The U.S. economy was on track to grow at a slower rate than the Fed initially assumed; borrowing costs around the world were declining for reasons unrelated to central banks; the record-breaking length of the post-2008 economic expansion reached millions who had been left behind in past times of prosperity; and the strength of the labor market did not force inflation higher.

He added that the Fed’s new approach focuses less on the inflationary risks of low unemployment, which did not bear out before the coronavirus crisis, and more on the benefits of a strong labor market.

The Fed’s new statement on monetary policy goals reflects that shift by focusing on “assessments of the shortfalls of employment from its maximum level” instead of “deviations from its maximum level.”

“This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” Powell explained.

The new framework adopted by the Fed on Thursday formalizes a shift that had been in the works for several years. Powell noted Thursday that the Fed cut rates three times in 2019 despite unemployment steadily declining to a 50-year low, a point at which the bank traditionally would had expected inflation to increase.

But Powell also sought to cast the new framework as the natural next step in the Fed’s path toward become a more transparent central bank focused more intently on the employment side of the dual mandate. He called out the shifts in approach from his predecessors — Paul Volcker’s crusade against stagflation, the moderation during the Alan Greenspan era, Ben Bernanke’s adoption of the 2 percent inflation target and Janet Yellen push to clearly outline the Fed’s approach to monetary policy.

“We believe that conducting a review at regular intervals is a good institutional practice, providing valuable feedback and enhancing transparency and accountability,” Powell said.

“And with the ever-changing economy, future reviews will allow us to take a step back, reflect on what we have learned and adapt our practices as we strive to achieve our dual-mandate goals.”