I think the US Federal Reserve (Fed)’s newly unveiled framework for its long-run goals and monetary policy strategy, combined with its recent statements, signals a fundamental change in how the central bank will conduct monetary policy from here on.
Prior to the 2008 financial crisis, the Fed would tend to hike interest rates when the unemployment rate fell below NAIRU.1 The Fed’s latest statement made clear that this is no longer a sufficient reason to raise rates, unless accompanied by inflation exceeding its target in order to deliver a 2% average inflation rate.
A closer look at the new framework
In general, the communique was dovish in that the Fed is basically saying that it will need to see both low unemployment and above-target inflation before it will consider hiking rates. The Fed’s policy rate is likely going to be floored at 0 for a long time. However, there are two ways in which the Fed’s current position is not quite as dovish as it seems at first glance.
One, while the Fed noted that it’s waiting on inflation, it was silent on its commitment to achieving higher inflation. I believe the Fed could engineer domestic inflation, but would need to expand its balance sheet aggressively enough to weaken the dollar. In my judgment, this was the mistake the Fed made from 2017 to September 2019. While the Fed was raising rates, it was also shrinking its balance sheet, the latter of which led to a strong dollar, tighter global liquidity, and muted global growth and inflation expectations.
Two, the Fed included financial stability as a third leg of its new framework, meaning concerns about financial stability could influence its policy stance. It’s easy to imagine a scenario where inflation is below target and unemployment remains high, while businesses and households use the low-interest-rate environment to take on higher levels of debt. In this case, the Fed would likely still keep rates at 0 to build credibility for average inflation targeting (AIT), but would also be likely to limit its balance-sheet growth in order to tighten monetary policy.
A word about financial stability
While financial stability has renewed impetus for the Fed, I do not think high — even frothy — stock prices would be enough in today’s environment for the Fed to change course and shrink its balance sheet. Rightly or wrongly, I believe the Fed learned from the 2000 recession that an equity bubble “popping” is not necessarily that dangerous to the long-term health of the US economy. In retrospect, the Fed may regard its dovish reaction to the 2000 market crash as excessive and as one factor that contributed to the housing market bubble from 2005 to 2007.
In my view, leverage-induced bubbles are what really scare the Fed. Thus, from the Fed’s standpoint, banks and non-financial corporate debt issuance are the truly important determinants of financial stability. I believe watching those will be key to understanding any changes to the Fed’s balance sheet.
I believe the Fed’s new policy framework marks a revolution in its approach to monetary policy — one that will likely affect global central banks that tend to follow the Fed’s lead. By flooring its policy rate at zero and adopting AIT, dismissing the idea of negative rates, and rejecting yield curve control, the Fed has very few tools left to support the economy or tighten policy other than its balance sheet. And recent history has shown that the Fed is not always an effective steward of that tool.
1”NAIRU” stands for “non-accelerating inflation rate of unemployment,” a theoretical level of unemployment below which inflation would be expected to rise.