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Powell signals monetary policy shift

Fed chairman signals toleration for higher inflation beyond traditional 2% target.

 

At the Jackson Hole summit on monetary policy, Fed chairman Jerome Powell said the Fed is moving explicitly to “flexible average inflation targeting”. In practical terms, this means, according to him, that after “periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”

Is today’s announcement a big game changer? Not really. The Fed was already unofficially in average inflation targeting mode, having chosen in 2018 to emphasise a “symmetric” inflation target of 2%, meaning it aimed for an overshoot of the 2% target after a period of undershoots. Persistently low inflation was a crucial justification, alongside rising US-China tensions, for the three ‘insurance’ rate cuts in 2019. Also, the change is much less ambitious than some had hoped. Some economists have been calling for the Fed to move its inflation target up to 3%, for example. Others want it to move to nominal GDP targeting (to take account of shortfalls in economic activity, not just inflation), and even more radical philosophies such as Modern Monetary Theory (MMT) are in vogue right now. Nonetheless, the shift in the Fed’s policy approach shows that, with interest rates effectively at the zero lower bound, worries of “Japanification” in the US are very much alive.

Yet the fact remains that despite its extremely accommodative monetary policy over the years, the Fed has not managed to lift inflation back to 2% (and average inflation expectations have actually tended to decline), so the Fed might find it tough to reach 2.5%, which could be an acceptable target. Also, some critics think that the Fed’s persistent dovishness translates mostly into higher asset prices rather than higher consumer prices.

One might speculate whether Powell’s latest statement conceals an approach to policy that is harder for the Fed to avow. We have long argued that the Fed is in a ‘debt dominance regime’, by which we mean that it is scared about triggering a debt-driven recession through tighter policy. But in its efforts to avoid such a recession, the Fed has been helping to fuel a debt bubble and increasing moral hazard risks. One might further wonder whether the Fed is now trapped in this regime given the sharp increase in already high public and private debt levels as a consequence of the covid-19 crisis.

In the near term, Powell’s comment make it likely that the Fed will shortly expand its asset purchases, currently running at USD120 bn per month: on top of signs of a plateauing of the economic recovery over the summer (see weekly jobless claims, Conference Board consumer confidence etc..), average inflation targeting is a good excuse to inject more liquidity into the system. In addition, Congress’s hesitation about extending the current fiscal stimulus could lead to a sharp decline in consumer spending in the coming weeks.