Federal Reserve to Maintain Low Interest Rate if Inflation Over 2%
New York, NY, August 28, 2020-The central bank unveiled a strategy in which it will tolerate periods of inflation above its 2% target to even out periods below, where it has mostly been since 2008, report the Wall Street Journal (WSJ).
“That’s likely to leave interest rates very low for a long time. The Fed said rate decisions would be guided by a desire to avoid employment shortfalls, rather than deviations above or below a certain employment level.
Writes the WSJ’s Greg Ip, “With the revamp of its monetary policy framework, the Federal Reserve has subtly but clearly shifted its priorities away from inflation to employment.
“The practical significance is small. With inflation already below the Fed’s 2% target and unemployment above 10%, interest rates were going to stay near zero for some years to come, and that hasn’t changed.
“But it’s an important institutional and philosophical shift. Like other pivots over the central bank’s 107-year history, this one comes in response to a changed world.
“Central banks have long operated on the assumption that there is a trade-off between employment and inflation. As the unemployment rate drops below some ‘natural’ level, inflation starts to rise, a relationship dubbed the Phillips curve. That means unemployment could be both too high or too low. The Fed in its old operating principles thus sought to minimize ‘deviations’ of unemployment from this natural level. In practice, this meant the Fed had to both estimate the natural rate and raise interest rates if actual unemployment threatened to fall below it.
“The new framework replaces ‘deviations’ with ‘shortfalls,’ implying unemployment can be too high but never too low. Two factors have driven this. The first is that the Phillips curve has flattened since the early 2000s. As unemployment fell to 50-year lows in the last year, inflation also stayed low. Fed Chairman Jerome Powell explained that the change in wording ‘may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.’”