Q&A on the Fed’s new policy framework

• The Federal Reserve last year announced important changes to its policy framework, adopting a flexible average inflation targeting (AIT) approach.
• Policy will now seek to achieve inflation that averages 2% over time. This will allow inflation to overshoot the Fed’s target to compensate for periods it stays persistently below it. Particular emphasis is placed on achieving maximum employment.
• We believe this constitutes a meaningful long-term shift by the Fed, which may also influence other major central banks currently conducting their own framework reviews.
• In this note, we address four questions covering key elements of AIT. In an separate bulletin, we discuss our detailed views on the US inflation outlook, and place them in the context of the Fed’s new framework.

What exactly did the Federal Reserve announce when it adopted a new framework?

Following an extensive review of its policy framework, the Federal Reserve (Fed) adopted an amended ‘Statement on Longer-Run Goals and Monetary Policy Strategy’ in August 2020. In it, the Fed did the following:

• Acknowledged the fall of “equilibrium” interest rates in recent years, which leaves policymakers with less space to cut rates when needed, as the fed funds rate frequently approaches zero
• Stressed that the maximum employment mandate is a “broad-based and inclusive measure” and linked its policy to shortfalls from this – not directly observable – level of full employment
• Changed its price stability goal to achieving inflation that averages 2% over time, promising to let inflation “overshoot” following periods when it runs persistently below 2%.

How does this differ from the Fed’s previous framework?

First, the shift puts maximum employment front and centre. The Fed already had the dual mandate of promoting maximum employment and price stability, but historically the focus on stable prices dominated. In the past, slight upticks in inflation at times sufficed to trigger a tightening cycle, while labour market slack was a lesser concern.

Now, the Fed is placing maximum employment ahead of inflation, and defining it broadly. In the policymakers’ assessment, the bigger picture will matter, not simply the achievement of a low headline unemployment rate. Chair Powell’s comment last week that the “true” unemployment rate is currently close to 10% illustrates this stance: Powell tells us it would be a mistake to look at the official unemployment rate of 6.3% and think maximum employment is in sight. Broader measures regarding participation, employment security, and wage growth must be part of the assessment.

In addition, the Fed is changing the nature of these objectives. The price stability mandate is seen as symmetric: it will seek to achieve inflation that averages 2% over time. This means that following periods of sub-target inflation the Fed will not simply aim for inflation to rise to 2% and then prevent “overshoots” by aggressively tightening policy, often pre-emptively. It will instead allow inflation to exceed the 2% for some time in order to compensate for past undershoots, so that the average level over the whole period is equal to 2%.

Meanwhile, as far as the employment mandate is concerned, policy becomes asymmetric. The Fed specifically wants to deal with shortfalls from maximum employment. In other words, a high unemployment rate (or insufficiently tight labour market conditions) will call for monetary stimulus. But a low unemployment rate will not push the Fed to tighten unless it actually generates sustained inflation. The Fed has learnt from experience that unemployment can fall below official “full employment” estimates (or NAIRU¹) and still not generate much inflation – in which case calls for tighter policy would be premature.