What will be the impact of changes in the US monetary policy framework?

In August, America’s central bank, the Federal Reserve, announced two important shifts in its monetary policy strategy. The extent to which these changes will affect the economic recovery depends on the expectations of households and firms about future inflation.

The US Federal Reserve (known as ‘the Fed’) is in the process of changing the way it conducts monetary policy. Following an extensive public review of its policy framework, the Federal Open Market Committee (FOMC) released a revised Statement on Longer-run Goals and Monetary Policy Strategy in August 2020. This included two significant revisions that signal important shifts in the conduct of US monetary policy.

The first revision means that policy decisions will now focus on ‘shortfalls’ of US employment from its maximum level. Previously, decisions were based on ‘deviations’ of employment from its maximum level. This single-word change in policy strategy means that the Fed is calling for stimulus to help kickstart growth when employment falls below some benchmark but no tightening to slow the economy when employment rises.

This change is a reaction to the widespread consensus that inflation has become less responsive to changes in the supply and demand for labour (or ‘labour market tightness’). In such an environment, lower unemployment can be sustained without threatening an inflationary spiral.

The second revision means that the FOMC will now seek to achieve inflation that ‘averages 2 percent over time’, rather than following a fixed inflation target of 2%. This means that after periods in which inflation has been running below 2%, monetary policy will aim to achieve inflation moderately above 2% for some time. By the same logic, the opposite is also true.

These changes reflect a view that risks to employment and inflation caused by changes in market conditions have generally increased. As this may be a temporary rather than a permanent phenomenon, the FOMC will continue to review its monetary policy strategy and make adjustments as appropriate, with an in-depth public review every five years.

What does this mean in the short term?

Today, with US employment running well below its maximum level, the first revision has no immediate implications. The Fed is still aiming to restore full employment. But the shift from a fixed to an average inflation target does have short-term implications.

US inflation, as measured by the year-on-year percentage change in the price index for personal consumption expenditures, has averaged 1.5% over the last decade, and averaged 1.2% in 2020 – see Figure 1.

Figure 1. US inflation (year-on-year percentage change in price index for personal consumption expenditures)

Source: US BEA, National Income and Product Accounts, Table 2.8.4.

If episodes of ‘below target inflation’ are to be followed by periods of ‘above target inflation’, this means that the Fed is now targeting an inflation rate somewhat above 2%. This is confirmed in recent FOMC statements: ‘With inflation running persistently below this longer-run goal, the Committee will aim to achieve inflation moderately above 2 percent for some time’.

Our analysis suggests that the near-term inflation target is 2.4-2.6%, depending on the length of the window that the Fed uses to compute average inflation (Holland et al, 2021). This is in line with recent statements by Fed officials: for example, Chicago Federal Reserve President Charles Evans has stated that he wants to see inflation hitting about 2.5% to help average out past underperformance.

What policy instruments can the Fed use to meets its higher inflation target?

As explained in an earlier piece on the Economics Observatory, in March 2020, the Fed responded to the Covid-19 crisis with its biggest ever policy programmes (Coroneo et al, 2021). It cut interest rates to near zero levels; used ‘forward guidance’ in the form of speeches and statements to indicate that it will keep interest rates at near zero for the next few years; reactivated its programme of ‘quantitative easing’ (QE), which entails the direct purchase of public and private sector bonds with the aim of driving market interest rates lower; and introduced new tools to support firm liquidity.

All of these measures (discussed in more detail in Coroneo et al, 2021) are designed to encourage companies to invest and employ workers, to encourage households to spend and to encourage banks to lend.

Since the release of its revised Statement on Longer-run Goals and Monetary Policy Strategy in August 2020, the Fed has not introduced any additional changes to these policy instruments: interest rates remain unchanged at near zero levels; and the pace of quantitative easing remains broadly unchanged. In other words, the forward guidance implicit in the new strategy is the only instrument that has been employed to guide inflation towards the Fed’s higher near-term inflation target.

Can forward guidance stimulate the economy in the short term?

Forward guidance aims to influence the expectations of households, firms and financial markets about future policies and the future state of the economy. The Fed’s ability to steer these expectations depends crucially on how individuals form their assessments. There is a longstanding debate in economics about expectation formation, which hinges largely on the extent to which individuals form ‘rational’ (forward-looking) expectations or ‘adaptive’ (backward-looking) expectations (Muth, 1961; Lucas, 1976; Sargent, 1993; Evans and Honkapohja, 2001).

Under rational expectations, individuals are assumed to have access to and use all available information to form their assessments. They do not, on average, make any consistent errors. In other words, under this assumption they have near perfect foresight. If inflation is going to be 2.5% next year, they will expect it to be 2.5% next year starting today.

Under adaptive expectations, views adapt sluggishly, with expectations of the future heavily dependent on the past. If inflation has been running at an average rate of 1.5% for a decade, individuals will expect inflation to continue running at 1.5% next year. They will adapt their expectations gradually if it turns out to be 2.5%.

Hybrid analysis of expectations falls somewhere between these two extremes. For example, one study considers a situation where people are ‘rational’, but their expectations are subject to a degree of error (Chadha and Corrado, 2007).

The extent to which the Fed’s shift from a fixed to an average inflation target will affect the economy in the short term depends on the nature of people’s expectations. If financial markets and other private sector organisations trust that the Fed will achieve a 2.5% inflation within a reasonable timeframe, this sets in motion a series of reactions that begin to drive inflation higher immediately (Barrell and Dury, 2000).

For a given level of interest set by the Fed, real (inflation-adjusted) interest rates will decline immediately, easing the borrowing conditions faced by households and firms, and stimulating investment. With interest rates expected to stay low for longer, investors in US financial assets will receive a lower rate of return. This will encourage a shift out of US financial assets, which will in turn push down the value of the US dollar.

As a result, the exchange rate will depreciate, pushing up imported inflation. As import prices rise, this will reduce demand for imported goods. At the same time, a weaker dollar makes US exports less expensive in the rest of the world, encouraging a rise in export volumes. Higher wage agreements will be set to meet the higher inflationary expectations. And finally, lower interest rates reduce the costs of buying assets such as housing. This will increase demand for housing and push up house prices.

All of these adjustments deliver an immediate uptick in economic activity. As firms face higher demand for the goods they produce, this may allow them to charge higher prices. Combined with higher wage agreements and the rise in import prices, this will drive inflation higher, towards the ‘expected’ inflation rate. As one study notes, the expectation of higher inflation, and the extra boost to activity that should go along with it, should reduce the monetary policy space (in terms of interest rate cuts or quantitative easing) required to reach the targets (Galí, 2020).

On the other hand, under backward-looking ‘adaptive’ expectations, the Fed is unable to deliver a stimulus purely through forward guidance. Forward guidance will not affect expectations in the short term, as individuals who form adaptive expectations adopt a ‘wait-and-see’ attitude – their inflation expectations will only begin to change after they have seen evidence of higher inflation. As a result, there is no immediate decline in real interest rates, no depreciation of the exchange rate, no rise in wage settlements and no rise in asset prices relative to the status quo.

One study warns that a central bank’s ability to steer expectations might be limited in the short term following an extended period of persistently below-target inflation (Bodenstein et al, 2019). If expectation formation tends to be more adaptive, individuals will want to see evidence of higher inflation before changing their view.

Expectations will eventually adapt if inflation is allowed to drift above 2% for some time. But we estimate that under adaptive expectations, the Fed would need to hold interest rates near zero for at least 24 months longer than under rational expectations, requiring significantly more monetary space (Holland et al, 2021).

Has the Fed managed to steer inflation expectations higher?

The capacity for the Fed to steer inflation expectations is vital to understanding what we should expect in the short term. To the extent that individuals form backward-looking, adaptive expectations, the change in policy framework may have little to no impact on near-term economic prospects. If individuals form forward-looking, rational expectations, the announcement of the new monetary policy strategy should act as a small stimulus to growth this year.

Figure 2. US inflation expectations (%)

Source: FRED, St. Louis Federal Reserve.
Note: Break-even inflation rate implied by yields on nominal and inflation-indexed bonds.

Some measures of US inflation expectations have indeed edged higher since August. For example, a measure of expected inflation can be derived from the difference between nominal and inflation-indexed government bonds of the same maturity. These have shown a gradual rise in the last few months and have recently reached close to 2.5% for the first time since 2014 – see Figure 2.

Over the same period, the dollar has depreciated against most other currencies. This may indicate that investors have started to buy into the Fed’s new higher inflation target. But it is too early to gauge whether these recent movements reflect a sustained shift. It is also difficult to disentangle the impacts of other major policy initiatives, especially in light of President Biden’s $1.9 trillion fiscal stimulus package (around 9% of US GDP).

The positive economic impacts of the US fiscal stimulus package could be larger under the Fed’s new monetary policy strategy compared with the previous strategy. This is especially the case if households and businesses expect the Fed to deliver on its promise to tolerate a higher level of inflation in the short term. How the Fed will respond to the fiscal stimulus in the context of its new monetary policy strategy will be a crucial factor for the pace of both the US and global economic recovery in the coming months and years.

Where can I find out more?

Review of Monetary Policy Strategy, Tools, and Communications: Documentation and research related to the Fed’s background review to the new monetary policy strategy
Do economists expect too much from expectations? Martin Weale reviews evidence on expectation formation.
Average is Good Enough: Average-inflation Targeting and the ELB: Bank of Canada study of average inflation targeting regimes.
Learning and Misperception: Implications for Price-Level Targeting: Fed study of expectations and price level targeting.
Average inflation targeting and household expectations: VoxEU column on early evidence on the response of household expectations to Fed’s new strategy.
The market-implied effects of the Biden stimulus and the Fed’s new policy framework: VoxEU column on monetary and fiscal policy interaction in the United States.
Modelling the change in US monetary policy framework in NiGEM: National Institute Global Economic Outlook, February 2021.