(Bloomberg) -- Federal Reserve Chairman Jerome Powell and his colleagues have made an important shift in their strategy for dealing with inflation in a prelude to what could be a more radical change next year.
The central bank has backed off the interest-rate hikes it had been delivering to avoid a potentially dangerous rise in inflation that economic theory says could result from the hot jobs market. Instead, Powell & Co. have put policy on hold until sub-par inflation rises convincingly.
“The Fed is evolving to a ‘whites-of-the-eyes’ approach in terms of inflation’’ under which it won’t hike rates until price rises accelerate, said Stephen Stanley, chief economist at Amherst Pierpont Securities LLC.
Powell and some of his colleagues have been perplexed and perturbed by the Fed’s failure to convincingly raise inflation to its 2 percent target. That’s what’s driving his seeming adoption of a show-me strategy on price pressures.
As the Fed embarks on a year-long review of its monetary policy framework, Powell’s also shown willingness to seriously consider an approach under which the central bank would seek price rises above its objective for a while.
Powell’s change in tactics has potentially major ramifications for monetary policy, the economy and financial markets.
Chicago Fed President Charles Evans said this week that the central bank may hold policy steady until the fall of 2020 and might even reduce rates in the unlikely event that underlying inflation softened.
Such a stance could eventually lead to faster price rises, lower unemployment and a longer expansion as officials refrain from raising rates to rein in the economy.
“Monetary policy has the luxury to be able to accommodate growth rather than having to slow down growth because of inflation,’’ said Angel Ubide, head of economic research for global fixed income at hedge fund Citadel. He expects the expansion to continue for several more years.
That would seem to be good news for President Donald Trump, who is up for re-election in 2020. But he’s not satisfied. He’s pressing the Fed to cut rates and resume bond purchases to turn the economy into a “rocket ship.’’
There are risks to the Fed’s evolving approach. A policy that keeps rates lower for longer could spawn speculative asset bubbles and excessive leverage as investors are forced to take on more risk to earn returns they’ve become accustomed to.
Then-Fed Chair Janet Yellen rejected a “whites of their eyes’’ strategy in 2016, arguing that the central bank needed to be pre-emptive in dealing with inflation because monetary policy acts with a lag. Powell, a central bank governor at the time, supported her.
The move to embrace that strategy now in part reflects the fact that monetary policy is in a different place. Short-term rates are two percentage point higher than they were then and policy is now reckoned to be neutral for the economy, not ultra-easy.
But what’s more important is what hasn’t changed. Price pressures have remained muted – even though the economy is coming off its best year since 2005 and is on course to achieving its longest expansion ever.
That’s fanned fears among Powell and his colleagues that companies and consumers may lose faith in the central bank’s ability to deliver 2 percent inflation. Since that objective was introduced in 2012, annual price rises have averaged just 1.4 percent.
Too low inflation also keeps rates dangerously close to zero. That gives the Fed scant room to cut in the next recession, meaning officials would once again have to resort to unpopular tools, such as bond purchases, to support the economy.
‘Make-Up’ Strategy
That’s the impetus behind the Fed’s decision to reconsider its inflation framework. While Powell has ruled out increasing the 2 percent goal, he’s raised the possibility that the central bank could adopt a “make-up’’ strategy when it concludes its review in the first half of 2020.
While that could take various forms, at its simplest it would involve the Fed seeking to achieve an average 2 percent inflation rate over the economic cycle. That would mean undershoots of the target when times were bad would be offset by overshoots when times are good, as they are now.
“I’m high on that idea,’’ Yellen told a Meridian International Center meeting on Tuesday in Washington.
It would be a marked departure from the Fed’s current let-bygones-be-bygones approach, where it tries to hit its symmetric 2 percent goal no matter what has happened before.
But for such a change to work, the Fed’s promise to deliver above-target inflation would have be seen as believable by the public.
That might be a difficult sell unless the central bank first convincingly lifts inflation to its 2 percent objective -- something the move away from a policy of preemption is meant to achieve.
“If we have not established the credibility of symmetry in our inflation target today, how can we expect any new approach to be credible?” Evans said Monday in New York.
