By Mark DeCambre
Wall Street is still weighing the implications of the Federal Reserve’s most substantive shift in the way it thinks about monetary policy in years.
In essence, Fed Chairman Jerome Powell on Thursday emphasized the primacy of the labor market in its mandate, even if it means that inflation rises above an annual 2% target that the central bank has traditionally deemed as indicative of a healthy, well-functioning economy.
Powell’s new policy framework comes after 18 months of review by the interest rate setting Federal Open Market Committee and marks a subtle tweak from targeting 2% inflation to now allowing for undershoots and overshoots that would see inflation average 2% over time.
“This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” Powell said in his webcast speech as a part of the annual Jackson Hole symposium on Thursday.
Indeed, the shift is a big deal experts say, and not just because of the defenestration of decades of central-bank orthodoxy centered on the relationship between the labor market and price pressures , but because it expresses policy that may be far removed from a policy such as advocated by Stanford University economist John Taylor, who has championed a mathematical approach to setting interest rates .
The Fed’s new approach, instead, may raise more questions than answers about implementation and crucially how it achieves inflation targets that have thus far remained elusive over the past decade.
“How much inflation is the Fed comfortable with?” asked Aneta Markowska, chief economist at Jefferies in a Friday research note.
“The FOMC was surprisingly vague with respect to its inflation averaging framework, saying merely that it will aim to achieve inflation ‘moderately above 2 percent for some time’ following periods of undershoots. What does that mean in practical terms? We simply don’t know,” the economist wrote.
After Powell’s Jackson Hole speech, some Fed officials did attempt to provide some sense of the degree to which inflation might be allowed to rise above the central bank’s target before raising alarms.
“To me, it’s not so much the number, whether it’s 2.5% or 3%,” Philadelphia Fed President Patrick Harker, a voting member of the FOMC, told CNBC in a Friday interview. “It’s whether it’s reaching 2%, creeping up to 2.5% or shooting past 2.5%,” he said.
St. Louis Fed President James Bullard, who is not currently a voting FOMC member, said on Friday that inflation could remain at around 2.5% “for quite a while.”
Inflation plays a key role in Fed policy because too-low inflation can lead to a weaker overall economy, as it can encourage consumers, the main driver of the U.S. economy, to delay purchases, as well as amplify expectations for even lower prices, fostering a potentially vicious cycle. As the Fed has put it , “if inflation expectations fall, interest rates would decline too.”
And receding interest rates make it difficult for the Fed to use its main tool for managing monetary policy: the federal funds rate. The Fed lowers its benchmark interest rate to stimulate economic activity and raises it to slow it.
It is worth noting that he Fed has raised interest rates nine times between 2015 and 2018.
However, from at least 2009 prices pressures have been nowhere seen, based on 5-year, 5-year forward inflation break evens, which are at 1.6%. That measure of inflation calculates the expected pace of price increases over the five-year period that begins five years from now.
A lack of clarity on the specifics around its altered policy could inject more uncertainty into the market over the longer term, experts said.
“When it comes to the shift in how the Committee views its inflation objective, much was left unsaid, and careful consideration suggests that the new approach may actually complicate the policy process in terms of both implementation and communication,” Robert Eisenbeis, chief monetary economist at Cumberland Advisors, in a Friday note.
Eisenbeis says that the Fed didn’t immediately specify which inflation measure it would use. Traditionally, the central bank’s preferred inflation gauge, is the PCE price index, or personal-consumption expenditures price index, but the commonly referenced gauge on Wall Street is the CPI, or consumer-price index.