What do changes in the Fed’s longer-run goals and monetary strategy statement mean?

What is the Federal Reserve’s “Statement on Longer-Run Goals and Monetary Policy Strategy”?

The Federal Open Market Committee (FOMC)—the Federal Reserve governors in Washington and the presidents of the 12 regional Fed banks—first published a Statement on Longer-Run Goals and Monetary Policy Strategy in 2012. That statement included the Fed’s first formal and public commitment to an inflation target of 2 percent. In 2019, three key economic developments  drove the FOMC to review that framework: First, estimates of the neutral level of interest rates—the level associated with full employment and inflation at target—continued to fall around the world. Second, inflation and inflation expectations continued to remain below the Fed’s 2 percent target. And third, unemployment fell to a 50-year low. The lower neutral rate means that the short-term interest rates that the Fed influences will generally be closer to (and more often hit) zero than had been previously contemplated—and that gives the Fed little room to cut interest rates in a recession. The inability to reach the inflation target is one indication that the Fed has insufficient firepower. The fact that unemployment has reached low levels without inflation is good news, since a strong labor market has widespread benefits, but the lack of an inflation response to low unemployment is another indication that reaching the inflation target might take longer than previously thought.

The Fed released an updated statement at the end of August 2020. The statement gives Congress, the public, and the financial markets a sense of how the FOMC currently interprets its congressional mandate—to aim for maximum employment and price stability—and the framework it will use to make decisions on short-term interest rates and other monetary policy tools. To compare the old and new Fed statements of long-term goals, see this guide. Going forward, the Fed plans to conduct a review of the statement every five years.

What major change did the Fed make to the statement and its framework regarding inflation?

Congress has given the Fed a mandate to aim for maximum employment and price stability.

Previously, the Fed said its definition of price stability was to aim for 2 percent inflation, as measured by the Personal Consumption Expenditures price index. It described that goal as “symmetric,” suggesting that it was equally concerned about inflation falling below or above that target.

In the new version of the statement, the Fed says it “will likely aim to achieve inflation moderately above 2 percent for some time” after periods of persistently low inflation. Fed Chair Jerome Powell called this strategy “a flexible form of average inflation targeting”—which Fed officials are calling FAIT—in an August 2020 speech at the Fed’s Jackson Hole conference.

Average inflation targeting implies that when inflation undershoots the target for a time, then the FOMC will direct monetary policy to push inflation above the target for some time to compensate. With this new approach, the Fed hopes to anchor the expectations of financial markets and others that it can and will do what’s needed to get and maintain inflation at 2 percent on average over time.

The new statement does not specify over what period of time the Fed will seek to have inflation average 2 percent or how much over 2 percent it intends to push inflation as part of this “make-up” strategy. Nor does it provide much guidance on the tools or methods that will be used to achieve an inflation target overshoot.

Asked why the Fed hadn’t provided specifics at a Peterson Institute for International Economics event, Fed Board Vice Chair Richard Clarida said: “The statement of longer-run goals and monetary strategy within the Fed is thought of as basically a constitutional—quasi-constitutional document, sort of at the 30,000-foot level of the parameters and objectives.”

What changes did the Fed make regarding its ‘maximum employment’ mandate?

The Fed has long monitored the unemployment rate relative to its projections of the long-run rate of unemployment, also known as the natural rate of unemployment or the non-accelerating inflation rate of unemployment (NAIRU).

The previous consensus statement included a numerical estimate of the NAIRU. However, given the uncertainty of real-time NAIRU estimates and the fact that the unemployment rate is only one measure of labor market tightness, the NAIRU estimate is no longer included in the statement. The quarterly Summary of Economic Projections will continue to show FOMC members’ long-run estimates of unemployment (effectively their projections of the NAIRU), but Powell suggested that these estimates will have less impact on policy decisions going forward.

The old statement said the Fed would adjust policy based on “deviations from its maximum level.” The new one says the Fed will base its decisions on “assessments of the shortfalls of employment from its maximum level.” 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,” Powell said.

The FOMC is essentially saying it will not raise interest rates just because the projected unemployment falls below its estimate of the NAIRU unless there are signs of inflation increasing to unwelcome levels. In practice, this means that the FOMC will allow recoveries to go on unimpeded by monetary policy—even if unemployment rates get very low—as long as inflation remains subdued. This more inclusive definition of the employment mandate is thought to be especially beneficial to minority groups and low- and moderate-income communities. Research shows that these groups get disproportionate gains from very low unemployment rates.

What does the new Fed statement suggest about the future course of interest rates?

Both major revisions point to easier monetary policy over the next couple of years. Allowing for low rates of unemployment and inflation overshooting makes it highly unlikely that the Fed will raise interest rates before inflation has been above 2 percent for some time. Under the previous framework, projections of unemployment rates below the estimated NAIRU or inflation headed above 2 percent may have each been reasons for the FOMC to hike rates.

Indeed, in his press conference that followed the December 2018 FOMC meeting—the last meeting at which the committee raised interest rates—Powell stated that going into 2018, strong growth had been “predicted to push the unemployment rate down to near historic lows, and the increasingly tight labor market was expected to help push inflation up to 2 percent.” This expectation, and stronger than expected growth in 2018 in part because of tax cuts, spurred the committee into four rate hikes in 2018. In a September 2020 speech at the Hutchins Center,  Fed Governor Lael Brainard suggested that the Fed may have acted differently in the post-crisis period under the new statement: “[H]ad the changes to monetary policy goals and strategy we made in the new statement been in place several years ago, it is likely that accommodation would have been withdrawn later, and the [employment] gains would have been greater.” But Janet Yellen, who was Fed Chair during the post-crisis normalization, said, “I think it would have made a small difference. I don’t think it would have made a huge difference.”

A New York Fed survey of primary dealers in July 2020 found that they don’t expect the Fed to raise interest rates until 2024.

What does the revised statement say about financial stability?

In August 2020 , Powell noted the trend that in recent years, “a series of historically long expansions had been more likely to end with episodes of financial instability, prompting essential efforts to substantially increase the strength and resilience of the financial system.”

Given this history, the new statement explicitly addresses financial stability concerns as an important part of the Fed’s mandate. “[S]ustainably achieving maximum employment and price stability depends on a stable financial system. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee’s goals.”

This change elevates financial stability in the Fed’s hierarchy of goals and suggests that, depending on the circumstances, the Fed may consider tightening monetary policy in response to financial stability risks if other tools (such as macroprudential regulatory policies) are inadequate. However, Brainard prioritized the use of regulatory policy over monetary policy to avoid instability. “It is vital to use macroprudential as well as standard prudential tools as the first line of defense in order to allow monetary policy to remain focused on achieving maximum employment and 2 percent average inflation,” she said.

What did the Fed not do?

In May 2019, Clarida suggested that the framework review was “more likely to produce evolution, not a revolution, in the way we conduct monetary policy.” This proved accurate.

When it launched the review, the Fed said it would not reconsider the wisdom of a 2% inflation target. Some economists have argued for a higher target. The Fed did not embrace any of the more far-reaching proposals for an alternative framework, such as nominal GDP targeting, price level targeting, or an inflation target range.  It ended up instead with something akin to proposals for temporary price level targeting.

The Fed currently relies on three main tools of monetary policy: adjustments to short-term interest rates, forward guidance, and quantitative easing. Adjustments to the policy interest rate, the federal funds rate, have long been the standard instrument for tightening or loosening the supply of money in circulation, and thus incentivizing economic participants to either save and curtail spending or to borrow and boost spending. With the policy rate anchored at the effective lower bound, forward guidance—promises about the future path of short-term interest rates—and quantitative easing—large-scale asset purchases by a central bank to put downward pressure on longer-term interest rates—have become integral parts of the FOMC’s attempts to make monetary policy more accommodative. The new statement acknowledges that the future path of monetary policy in the U.S. is likely to be constrained by the effective lower bound with greater frequency.

Other central banks have used additional tools such as negative interest rates and yield curve control to deal with the constraint of the effective lower bound. Current FOMC members believe that negative interest rates are not a desirable option for the Fed. Yield curve control remains in the toolkit, but not for right now, Fed officials have said. Expanding the Fed’s authority so it can buy corporate bonds in ordinary times, as the European Central Bank and Bank of England can,  would require Congressional approval.

What have been the reactions to the new framework?

The changes in the Fed’s goals statement were consistent with expectations—in part because the process of developing them was so public—so there was little immediate financial market reaction.

There was some disappointment that the committee did not provide information about any new tools to accomplish its goals. As former Fed Governor Larry Meyer put it, “There was essentially no innovation in terms of the FOMC’s tools. The previous statement said nothing about the Fed’s tools, and the new one says little more.” On their Money, Banking and Financial Markets blog,  Stephen Cecchetti and Kermit Schoenholtz questioned the credibility of the Fed’s new goals: “Having consistently fallen short of the 2% inflation target since it was announced, why should anyone believe that they can boost inflation above 2% anytime soon?”

At a Hutchins Center event, former Fed Chairs Janet Yellen and Ben Bernanke praised the Fed’s revisions to the framework. “I think it will strengthen monetary policy,” Bernanke said, because long-term interest rates will reflect market understanding of what the Fed intends to do when the economy recovers from the COVID-19 pandemic. “Makeup policies create a lower-for-longer dynamic. That, in turn, adds accommodation even while rates remain at zero,” he said. As for the lack of specificity in the Fed’s new strategy, Bernanke said he expects the Fed to elaborate in the near future: “[T]he statement that they have agreed upon can be thought of as a constitutional statement. I expect that sometime this fall the Fed will come out with explicit forward guidance that will give us some more sense of how they imagine meeting this standard.”

Yellen endorsed the adjustments to both the inflation and employment goals of the Fed, but also acknowledged “they still need to translate this into something more operational. They need some forward guidance about the path of rates and asset purchases.” Yellen also emphasized the importance that the FOMC unanimously endorsed the statement, adding to its credibility.

Given that inflation is below the Fed’s 2-percent target and unemployment is so high due to the COVID-19 pandemic, the changes that the Fed made are not likely to have any big, immediate impact on monetary policy decisions—though it could affect the wording of the Fed’s forward guidance on rates and asset purchases in the near term. But as the economy recovers, the restatement will become more important—and suggests that the Fed will be holding off on tightening monetary policy even if the unemployment rate falls back to where it was before the pandemic and even if inflation is projected to rise above 2 percent.