Jerome Powell spoke Thursday during the Jackson Hole economic symposium, which was held virtually.
Photo: Daniel Acker/Bloomberg NewsThe Federal Reserve approved a major shift in how it sets interest rates by dropping its longstanding practice of pre-emptively lifting them to head off higher inflation, a move likely to leave U.S. borrowing costs very low for a long time.
The move Thursday won’t lead to a significant change in how the Fed is currently conducting policy because it had already incorporated the changes it formally codified Thursday.
But the shift marked a milestone. Had the strategy been adopted five years ago, the Fed would have likely delayed rate increases that began in late 2015, following seven years of short-term rates pinned near zero. By signaling Thursday it wanted inflation to rise modestly above its 2% target, the Fed revealed how the global central bank principle of inflation targeting, widely adopted over the last quarter century, may have outlived its usefulness.
Fed Chairman Jerome Powell initiated a policy-setting strategy review in late 2018, motivated by the sobering probability that central banks around the world will face greater difficulty than in the past to spur growth due to low levels of interest rates.
The coronavirus pandemic-induced recession brought those challenges into stark relief. The Fed cut its benchmark rate twice in March to near zero from a range between 1.5% and 1.75%, and it has bought trillions of dollars of government assets to stabilize markets
Mr. Powell said in a speech delivered online the Fed was applying lessons of the recent past in unveiling the most ambitious revamp of its policy-setting framework since it first approved a formal 2% inflation goal in 2012.
One of those lessons would be to place less emphasis on forecasts assuming a given level of low unemployment would produce higher inflation and instead wait for evidence that inflation was at the central bank’s 2% target. That means the Fed would let unemployment fall to historically low levels before raising rates, a step seen as controversial just a few years ago.
“It reflects our view that a robust job market can be sustained without causing an outbreak of inflation,” said Mr. Powell.
If investors believe the Fed’s words are credible, the changes announced Thursday “will increase the accommodative power of policy,” said former Fed Chairman Ben Bernanke. “When you go into a recession, markets will expect a longer period of easier policy and that will, in turn, increase the amount of effective stimulus.”
The changes also set the table for the Fed to provide more specifics about how long it expects to keep interest rates low as soon as its Sept. 15-16 meeting. It could do that by putting forward an inflation threshold and a qualitative description of labor market conditions that would warrant higher rates.
Separately Thursday, the Commerce Department revised its estimate of second-quarter economic growth, saying gross domestic product fell at a 31.7% annual rate, slightly less than its earlier estimate of 32.9%, due to the effects of the coronavirus pandemic.
The second-quarter contraction was the sharpest in more than 70 years of record-keeping. But the annualized figure assumes the economy shrinks at the same pace for a year, which analysts don’t expect. Other recent data indicate output is growing in the third quarter.
Unemployment claims fell slightly last week but remained historically high, signaling layoffs continue as the coronavirus hampers economic recovery. New applications for unemployment benefits ticked down to 1 million in the week ended Aug. 22, the Labor Department said Thursday. Initial unemployment claims remain well below the recent peak of about 7 million in March but are far higher than pre-pandemic levels of about 200,000 claims a week.
The Fed had been moving in a new direction over the last 18 months, a point made clear in early 2019 when officials abruptly abandoned plans to continue lifting interest rates and later when the Fed cut interest rates last summer.
“The important changes have really already happened,” said William Dudley, who was president of the New York Fed from 2009 to 2018. “People already know the Fed wants to see inflation above 2%. This is a recognition of something that has been pretty implicit for a while.”
In 1977, Congress directed the central bank to maintain stable prices and to boost employment. Lawmakers weren’t precise about defining those goals, and after several years of discussion, Mr. Bernanke formally established a 2% target in 2012.
The nearly two-year strategy review was designed in part to put Congress on notice that the central bank was preparing to revise its interpretation of that delegated authority once again. The Fed also said it would conduct a similar, formal review every five years.
The Fed believes the economy runs best when businesses and consumers behave as if inflation will even out over time despite short-run ups and downs. Fed officials chose 2% as a compromise of sorts—a level low enough that consumers don’t factor it into their daily decisions but not so low that it leaves the Fed unable to counteract downturns when interest rates fall to zero.
While the Fed didn’t change its 2% target on Thursday, it made an important and widely anticipated shift by stating that if inflation runs below 2% following economic downturns, it will seek periods of inflation above 2% when the economy is stronger to prevent expectations of future prices from sliding lower.
The Fed didn’t specify exactly how high or how long it would allow inflation to rise above 2%.
Officials enshrined the conclusions of its strategy review on Thursday by formally approving a revamp of the central bank’s statement on longer-run goals and monetary policy strategy. Mr. Powell secured agreement from all 17 officials who participate in the Fed’s rate-setting deliberations.
The Fed and the Pandemic
For years, the Fed justified plans to withdraw stimulus as the economy recovered by warning that waiting too long to do so could provoke an acceleration of price pressures, particularly as joblessness fell below a level expected to push prices higher, sometimes referred to as the natural rate of unemployment.
The Fed said Thursday that decisions to raise interest rates would be guided by a desire to avoid shortfalls of unemployment from its maximum level rather than all deviations above or below the maximum level.
“They believe, and I agree, that there are substantial social benefits from a strong labor market,” said Mr. Bernanke. “Under this strategy, they will not take any steps to cool the labor market unless there is clear evidence of inflationary pressure.”
Some critics warned that the changes would do little to boost growth and instead would propel asset prices to higher levels, creating financial instability. Others had recommended even bolder steps, such as raising the inflation target, to avoid the low-inflation trap that has hampered central banks in Japan and Europe.
The Fed is committing to stay off the brake pedal for longer, but Mr. Powell said little Thursday about any additional tools the Fed might deploy to press harder on the gas.
“They’re not good at pushing on the gas. We’ve seen that for 20 years in Japan,” said Adam Posen, president of the Peterson Institute for International Economics. “They can’t force people to buy durable goods. They can’t force banks to lend. They can’t force companies to invest.”
When the Fed adopted its 2% inflation target in 2012, short-term rates were pinned near zero, as they are today. But central bankers, economists and investors largely expected them to return over time to more normal levels of 4% or so once the economic expansion matured.
Even before the pandemic hit, those rates were stuck at much lower levels than 4% for reasons that weren’t expected to change soon, such as demographics, globalization, technology and other forces that have held down inflation.
“The Fed is playing a hand of cards that is missing some of the face cards. It is dealt on a routine basis a less powerful hand of cards,” said David Wilcox, a former top Fed economist. “It behooves the Fed to play its hand as well as it possibly can.”
Meantime, the Fed had described its 2% target in recent years as symmetric, meaning 2% wasn’t a ceiling. Under the approach, the Fed wasn’t taking past misses of the target into account.
Except for a brief period in 2018, inflation ran below the target but never above it. While those misses were relatively small, Mr. Powell said they were concerning because failing to achieve the target could lead to harmful declines in businesses’ and consumers’ expectations of future inflation.
“The persistent undershoot of inflation from our 2% longer-run objective is a cause for concern,” Mr. Powell said Thursday. While it might be counterintuitive for the Fed to desire more inflation, particularly given rising costs for certain items like housing, Mr. Powell said the Fed needed to avoid “an adverse cycle of ever-lower inflation and inflation expectations.”
The dynamic is particularly troubling because expected inflation feeds directly into the general level of interest rates, he said. Lower inflation deprives central banks with already-low interest rates of tools to counteract downturns.
“We have seen this adverse dynamic play out in other major economies around the world and have learned that once it sets in, it can be very difficult to overcome,” said Mr. Powell. “We want to do what we can to prevent such a dynamic from happening here.”
Write to Nick Timiraos at nick.timiraos@wsj.com
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