What is the Fed’s new policy framework, and why is it doing so?

(Reuters) – Here are five things to know about the Federal Reserve’s new strategy for achieving stable prices and maximum employment. The divisive policy shift was announced on Thursday.

FILE PHOTO: Federal Reserve Board building on Constitution Avenue is pictured in Washington, USA, March 19, 2019. REUTERS / Leah Millis / File Photo


The new strategy places more emphasis on strengthening the labor market and less on worries about high inflation.

Full employment “a broad-based and inclusive goal” the new policy statement calls for the US Federal Reserve to make policy decisions based on “deficits” of full employment. ”

The new language signals the Fed will continue to fight unemployment that is too high, but that it will not raise the alarm about unemployment falling too fast or too far, as it did in the past.

The new strategy also includes a loose form of average inflation target, under which the Fed aims to create periods when inflation is too low by allowing periods when inflation is too high. Over time, inflation would average 2%.

What does it mean for the economy?

Under the old framework, a drop in unemployment to super-low levels was treated as an early warning signal for unwanted inflation.

But that never happened. Before the coronavirus pandemic hit, the US unemployment rate had fallen to 50-year low, and there was no sign of an inflationary trend. The new framework takes that lesson into account, leaving room for the Fed to keep policies loose, even as employment grows.

While the new approach may mean higher prices for food and other essentials, Fed Chairman Jerome Powell said in the shift statement that it is a price worth paying to keep inflation from falling too low and for achieving a stronger labor market.

HOW would it work?

Since inflation has been under 2% for years, the strategy means that Fed policymakers will not even think about raising interest rates until inflation exceeds their 2% target for a while.

The idea is that if households and businesses are convinced that inflation is rising, resulting in a reduction in their future purchasing power, they will take steps to borrow, spend and invest their money sooner.

That burst of early spending in a downturn should help create jobs and boost demand, pulling the economy out of the slump faster.

In the meantime, the Fed’s new focus on suppressing unemployment could help bring a broader group of workers back into the labor market.

WHAT Could Go Wrong?

For the strategy to work, households and businesses must believe that Fed policymakers have shed the mindset of inflation fighters and have fully embraced a new role as guardians of a strong labor market.

And they have to buy into the idea that a little bit of inflation is indeed a good thing, especially if it allows for more labor supply.

In addition, keeping interest rates low for an extended period tends to raise stock prices, perhaps benefiting wealthier Americans more than the lesser ones, whose well-being seems to be at the heart of rewriting the new framework of the Fed.

Another problem: Just because the Fed says it welcomes higher inflation does not mean it can actually generate it. The actual mechanics of how it would design higher prices are absent from the new document, although it promises to use its full range of tools to achieve its goals.

Why a new framework?

The Fed has worried that its recession-fighting tool will not work well in a world where inflation and interest rates are lower than they have historically been, leaving the Fed less room to fight declines with its traditional tool to lower interest rates. cut.

The centerpiece of the Fed’s previous framework, adopted in 2012, was an official 2% inflation target – low but above zero enough to provide a buffer against growth-sluggish deflation in a downturn.

But in the years that followed, the economy did what Fed policymakers did not expect: despite years of near-zero interest rates and trillions of dollars worth of bonds, inflation remained stubbornly below target.

And low inflation, in turn, meant that the Fed had little room to help the economy once it faltered just by lowering rates. To address the current crisis, the central bank has had to resort to politically charged tools such as stock purchases and direct loans to companies.

The overhaul is not specifically aimed at helping the Fed combat the deep recession caused by the coronavirus, although it could be a test case.

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