Monetary Policy Framework: The Fed Says What, But Needs Help on How

The Federal Reserve released the results of its multiyear framework review alongside a speech by Fed Chair Jerome Powell at the Kansas City Fed’s Economic Policy Forum on 27-28 August. While the announcement came earlier than anticipated, the conclusions were in line with the evolutionary, not revolutionary, changes to the Fed’s framework we have long been expecting.

The Fed’s revised “Statement on Longer-Run Goals and Monetary Policy Strategy” revealed the central bank’s preference to average 2% inflation over time, but stopped short of implementing a new inflation-targeting rule or preferring anything more than a “modest” overshoot of the inflation target. (The Fed’s preferred inflation measure is the core PCE (personal consumption expenditures) deflator.)

The other key conclusion from the framework review was an emphasis of the benefits of allowing the labor market to reach maximum employment, made official in the statement via a switch to an asymmetric unemployment objective.

We view the framework review results – and the forward guidance that we expect to follow soon – as confirming what we already believed about the Fed’s desire to overshoot 2% inflation in order to correct for past inflation shortfalls. It’s not a significant paradigm shift. Given the modest changes in the monetary framework and interest rates at the zero lower bound, the key question is whether these adjustments will be sufficient to engineer the inflation overshoot the Fed desires. With today’s high level of slack in the economy expected to dissipate only gradually, we think fiscal policy, not monetary policy, will be the key determinant of the Fed’s success in reaching its inflation objective over the next several years.