The New Framework of the Fed’s Interest Rate Policy－Key Developments and ImplicationsInsights SRD/New York Research Center
In August 2020, the Federal Reserve released its “Statement on Longer-Run Goals and Monetary Policy Strategy,” which established a new framework for its interest rate policy.
1. Developments and features of the new framework
- Key contents
On the dual mandates of interest rate policy and its weight: In the past, the Fed took into account both the deviation of inflation from its long-term target and the deviation of employment from its perceived maximum level when adjusting interest rate policy. The new framework would eliminate both these mandates, , which means that the Fed's inflation target will remain symmetrical. The employment target, on the other hand, is an emphasis on being below the Fed's maximum level, as it seeks to target the lowest level of unemployment possible. Low unemployment itself is no longer a sufficient condition for raising interest rates.
On employment targets: The new framework claims that the maximum level of employment cannot be directly measured and will change over time, so it is not suitable to set fixed employment targets. Instead, it needs to assess the gap below the maximum level of employment. The maximum employment goal of the new framework will be more broad-based and inclusive. The Fed recognizes that a lower unemployment rate leads to a broader and more inclusive job market, which will benefit low-income groups who have been significantly impacted by the COVID-19 outbreak.
On inflation targets: The Fed believes that anchoring long-term inflation expectations at 2% is the key to maintaining price stability and achieving the inflation target. To do so, the Fed would aim for an average inflation rate of 2%, allowing inflation to remain moderately above 2% for some time, following periods when inflation has been running persistently below 2%.
- New developments and features
-The Fed will not use any particular mathematical formula to define the average and does not seek to achieve average inflation in a specified period of time. It follows more of a flexible regime, indicating that the Fed abandoned its rules-based decision-making model in favor of a more discretionary approach. The new framework is no longer based primarily on the deviation of recent inflation data from the target, but rather on the longer historical, present, and expected state of inflation.
-Replace symmetry inflation target with a Flexible Average Inflation Target (FAIT): In the past, the Fed used symmetry to describe the 2% inflation target in order to emphasize the target’s long-term nature and to allow it to be exceeded. The new framework no longer mentions symmetry and allows the Fed to emphasize the flexibility of the average inflation target, as the 2% average can only be achieved under asymmetric conditions. Without symmetry, the Fed has more room to raise its inflation target and keep interest rates lower for longer.
-Pay less attention to the natural rate of unemployment: Given the uncertainty of the natural rate and the fact that the unemployment rate, which is lower than the natural rate, is not sufficient as a leading indicator of the accelerated rise in expected inflation, the Fed downplayed the natural rate and is also no longer using the unemployment rate and its deviation as an important criterion for assessing the state of the job market and the rate decision.
2. The effects, limitations, and challenges of the new framework.
The Fed's adoption of the new framework, in particular the average inflation target, has a positive effect on promoting economic and employment growth in a recessionary environment. In addition to longer-term low-interest rates, the market is likely to raise inflation expectations, which could increase spending and debt.
The Fed is unlikely to allow inflation to grow too fast, but will ensure that inflation and growth are balanced in the long run. However, there are still many limitations, challenges, and uncertainties in the implementation of the framework.
-Macroeconomic impact: The Fed's action to increase inflation helped raise market expectations for inflation over the next five to ten years, which in turn led to a rise in long-term interest rates. In an environment of rising debt levels, this can lead to a higher debt burden, affecting the pace of market recovery and debt sustainability. Expectations that the Fed will maintain ultra-low interest rates and ample liquidity over the long term will also further increase debt and encourage investors to invest in riskier assets, which may deteriorate asset quality.
-The Fed's experience and effectiveness in adopting interest rate policies to deal with inflation are not symmetrical. The Fed has significantly greater experience dealing with rising inflation versus falling inflation, and it generally is less successful when dealing with raising inflation versus reducing inflation. While the new framework gives new opportunities for the Fed to achieve inflation, it is also more difficult to operate.
-The effects of a flexible and discretionary approach to maintaining inflation expectations depend on the Fed’s ability to communicate and interpret its policy intentions. Although the new framework is more flexible, market uncertainty remains about policy direction. The average target regime is more likely to anchor long-term inflation expectations at 2%, but without clarity on operational details, it may be more difficult to anchor short-term expectations. Markets may speculate on the targets for the next period, which makes it difficult to reach a consensus around inflation expectations. The key questions will be: How long does it take for the average inflation target to be calculated? How long and to what extent can inflation expectations deviate from 2%?
At the September FOMC meeting, the Fed made it clear that it would target inflation of moderately above 2% for some time to meet its long-term inflation target, which is an average of 2%, and anchor market expectations.
The Fed also conditioned its next rate hike on the basis of full employment and inflation targets,and is likely to establish further guidance about the terms of its next rate hike at each FOMC meeting in the future.
However, the Fed's adoption of FAIT means it may not specify the details of the overall framework. While this frees up a lot of room for the Fed's future flexibility, it adds more uncertainty to market expectations around policy direction. The Fed's ability to successfully anchor inflation expectations will not only depend on its ability to communicate that goal clearly, but also the market's trust in them.
3. Implications for Banks
- To evaluate the maturity and effectiveness of the new framework, the market needs to observe how the Fed interprets the details of the regime and whether the changes in inflation expectations in the near to long-term are consistent with the Fed for at least one cycle. The key indicators will be 5- and 10-year Treasury interest rates and their breakeven inflation rates, as well as other inflation expectations indices.
-The rising inflation expectations are driving the long-term Treasury rates up, while the short-term rates determined by the Fed fund rate remain low, resulting in a steeper yield curve. A steepening yield curve would be favorable for banks’ NIM improvement, and banks need to adjust their balance sheets accordingly in order to take advantage of the situation.
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