Powell steers new strategy for a world where very low rates are no sure thing
Summary
Forthcoming changes to the Federal Reserve’s rate-setting framework are unlikely to influence officials’ current decisions. But the expected changes acknowledge that the ‘lower-for-longer’ interest-rate era may be over.
Federal Reserve Chair Jerome Powell said the central bank was in the process of making adjustments to its overarching policy-setting framework to account for meaningful changes in the outlook for inflation and interest rates following the 2020 pandemic.
“The economic environment has changed significantly since 2020, and our review will reflect our assessment of those changes," Powell said Thursday.
The Fed adopted its current framework five years ago, and it began a review of that framework this year. The review isn’t likely to influence how the Fed is currently setting interest rates. Powell has previously said the Fed could complete that process and unveil the results by August or September.
Powell spoke at a research conference at the central bank’s headquarters in Washington. There, officials will hear from leading policy theorists over changes they should potentially make to their framework and communications tools.
Powell suggested that higher inflation-adjusted—or “real"—interest rates that followed the 2020 pandemic could moot elements of the bank’s current framework.
Higher real interest rates might “reflect the possibility that inflation could be more volatile going forward than in the intercrisis period of the 2010s," he said. “We may be entering a period of more frequent, and potentially more persistent, supply shocks—a difficult challenge for the economy and for central banks."
The Fed meets every six to eight weeks to vote on changes to interest rates and releases a policy statement explaining its decision. The framework review is focused on a separate document, typically reissued every January, that outlines the Fed’s approach to setting rates.
The Fed formally defined an inflation target of 2% in 2012. But the very low global interest-rate environment that followed the 2007-09 recession led officials to grow concerned that their new inflation target might have a flaw: With interest rates pinned more often near zero, the central bank might lack the ability to stimulate growth following downturns.
As a result, the Fed faced a wider range of scenarios where it would be easier to slow down the economy by raising rates than to stimulate the economy by cutting rates. Six years ago, the Fed embarked on a yearlong effort—its first “framework review"—to consider changes that would account for this asymmetry.
Powell led his colleagues in adopting a new framework in 2020 that made a seemingly small but important change. Inflation had been running below the Fed’s 2% target even with historically low interest rates. So officials agreed to a “make-up" strategy: They would keep interest rates somewhat lower than widely used models might suggest, allowing inflation to run modestly above their 2% goal. Officials agreed to revisit their framework every five years.
At their meeting last week, officials concluded they should revise this so-called average inflation targeting that they adopted five years ago, Powell said Thursday.
The reopening from the pandemic in 2021 rendered the most notable changes of the 2020 framework inoperable by year’s end. Inflation hit 6% in November 2021. This “overshoot," driven by strong demand and discombobulated supply chains, hadn’t been contemplated by officials when they adopted the framework one year earlier.
“The idea of an intentional, moderate overshoot proved irrelevant to our policy discussions and has remained so through today," Powell said on Thursday.
The Fed’s current review represents central bankers’ attempt to reckon with the deficiencies of the 2020 approach—specifically, that it wasn’t resilient to a broad range of economic outcomes, however unlikely they seemed at the time.
But the review is likely to preserve the core ideas behind the Fed’s framework, including its 2% inflation target and the critical role of making sure the public believes the central bank will keep inflation low and stable. Officials think those inflation expectations are self-fulfilling and have played a big part in facilitating a decline in inflation over the last two years without a big increase in unemployment.
Without the public believing inflation would decline back to levels seen before the pandemic, “it would not have been possible to achieve" the recent decline in inflation “without a spike in unemployment," Powell said.
Write to Nick Timiraos at Nick.Timiraos@wsj.com
