The Fed’s New View on Inflation, Japan’s Struggles, and Housing’s Health

summary

• The Fed Reframes Its Framework
• Japan Is Behind The Curve
• Housing Stays Healthy

Invitations to each summer’s central banking conference in Jackson Hole, Wyoming, have historically been greatly limited and highly coveted. The pandemic forced this year’s edition to take place virtually, and the host of the event, the Federal Reserve Bank of Kansas City, opted to make the live proceedings available to the public. The opening day drew more than 62,000 viewers.

Technology wasn’t entirely cooperative; the opening speech from U.S. Federal Reserve Chairman Jerome Powell had some of the fits and starts that have become familiar to regular users of videoconference platforms. But Powell provided some clear and significant insights for the broader audience.

At the beginning of last year, the Fed initiated a review of its policy framework aimed at refining the objectives of monetary strategy and finding ways to communicate more effectively. Powell’s prepared remarks for this week’s summit summarized the content of the new framework, which was published as he spoke.

The economic experience of the second half of the past decade provided the impetus for the review. In spite of the strongest labor market the U.S. had seen in 50 years, inflation remained stubbornly low. The Fed’s macroeconomic models, which still factored in Phillips Curve effects, were proving increasingly unreliable.

Further, the Fed’s long-run estimates of potential economic growth and equilibrium interest rates declined significantly between 2015 and 2019. Those quantities are important to the setting of monetary policy: they help to indicate whether activity is running hot or cold and whether financial conditions are easy or tight. Without accurate barometers, it is hard to gauge the economic climate.

As usual, academic papers and discussion were an integral part of the Fed’s review. What was unusual about the review was the series of 15 “Fed Listens” events around the country that sought to understand the impact of monetary policy in all places and at all levels of society.

The outreach was a clear recognition of the Fed’s sense of responsibility to the public. As Powell observed, “Public faith in large institutions around the world is under pressure. Institutions like the Fed need to aggressively seek transparency and accountability to preserve our democratic legitimacy.”

“The Fed’s listening tour proved to be very impactful to its thinking.”

The “Fed Listens” tour included an impactful stop in Chicago last summer. Representatives from community organizations spoke passionately about the importance of a strong job market to the quality of life for many citizens. At the time, the U.S. labor market was finally bringing opportunity to those who had been out of work for long periods, validating the Fed’s decision to refrain from raising rates even as joblessness fell below estimates of full employment.

The pandemic delayed and added impetus to the Fed’s review. In just two months, the U.S. economy lost all of the jobs created during the record expansion of the last decade, and then some. Those with more modest skills and wages have been hardest hit. It was clear from Powell’s remarks that he and his colleagues are dedicated to doing whatever they can to restore opportunities for those who have been displaced.

Having taken a great deal of time and care to arrive at the right strategy, the Fed was finally ready to release it to the public. Here are some of the key elements:

• Policy will seek inflation that averages 2%, meaning that if actual inflation falls short of that target for a period, the Fed will strive for slightly higher inflation. This is a minor refinement of the “symmetric” 2% inflation target that the Fed has described for some time now.
• Maximum employment, the Fed’s other policy objective, will be viewed from a broad and inclusive perspective, and policy will be based on shortfalls from its maximum level. This acknowledges that employment can exceed perceived limits without stressing inflation.
• The Fed made more explicit mention of financial stability as a component of its policy evaluations.

Taken together, the changes announced this week will likely lead U.S. monetary policy to be easier for longer, in the current environment and across the business cycle. The Federal Open Market Committee may take steps to incorporate this direction into the forward guidance it offers at its September meeting.

The updates to the Fed’s framework were carefully considered, and certainly not rushed. But questions surrounding its implementation remain. Powell insisted that policy setting would be flexible and not formulaic, meaning decisions will continue to be based on unobservable quantities (like the long-run equilibrium levels of unemployment and interest rates) and subjective judgment. Markets will still not have perfect clarity around how the Fed will react to different situations.

“The Fed cannot achieve its objectives on its own.”

As well, the Fed has still not demonstrated that it can achieve 2% inflation consistently. As we noted in our treatise on alternative inflation targeting regimes, raising the bar when you have failed to clear the last height might raise more questions than it answers. Both inflation and unemployment are subject to numerous domestic and global forces that are beyond the Fed’s control; the current pandemic is a prime example. Monetary policy cannot compensate for all of these limitations.

To accompany its new framework, the Fed released a series of discussion papers covering its views on unemployment benchmarks, the use of the balance sheet, and the influence of financial stability concerns on policy. We’ll be reading them closely, and will offer a summary for you next week.

This week’s releases reflect a lot of hard work from the Fed. Given current circumstances, it still has a lot of hard work ahead.