After Inflation Targeting, Here's What The Fed Will Do Next

For those who missed the day's main event, in a speech whose content was widely anticipated, this morning Fed Chair Jerome Powell announced that the FOMC has adopted a flexible form of average inflation targeting as the key outcome of its monetary policy framework review. The FOMC simultaneously released an updated Statement on Longer-Run Goals and Monetary Policy Strategy. The new statement includes dovish revisions to the FOMC’s approach to both its employment and inflation objectives.

Here are the biggest changes:

  • On the inflation side, the statement notes that the FOMC “seeks to achieve inflation that averages 2 percent over time,” and that “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.” Powell did not reveal the timeframe in question, noting that the Fed is not tying itself to a particular mathematical formula (which led to an initial market disappointment), and that the approach could be viewed “as a flexible form of average inflation targeting.” Powell noted that the change comes in response to concerns about inflation persistently falling below the Fed’s 2 percent longer-run objective, but also noted that if inflationary pressures were to build, the Fed "would not hesitate to act."

  • On the employment side, the statement now says that policy will be informed by its assessment of “shortfalls of employment from its maximum level” rather than “deviations,” the language previously used. This change represents a shift toward an asymmetric response to the employment gap under which an unemployment rate below the estimated natural rate of unemployment is not a sufficient reason on its own to tighten policy. In other words, if unemployment hits a new all time low in the coming years, that will no longer be a sufficient condition to tighten. The new statement also now describes the maximum level of employment as a “broadbased and inclusive goal.”

As Goldman's Jan Hatzius writes in a his post-mortem, today’s developments are "a significant dovish long-term shift for the Fed, but one roughly in line with expectations" even though the markets were first disappointed and then acted as if they were surprised, with the S&P hitting 3,500 for the first time.

In Goldman's assessment, "the new policy introduces an element of make-up inflation, but characterizes the approach as flexible, stops short of a hard formulaic commitment, and expresses the intention softly as “likely” to imply inflation “moderately” above 2% “for some time.” More importantly, the statement continues to note that the FOMC will respond to "risks to the financial system that could impede the attainment of the Committee’s goals." In short, the Fed's true mandate remains keeping markets elevated.

Of note, neither Powell’s speech nor the revised statement noted meaningful changes arising from the tools or communication practices sections of the review. According to Goldman, this means that there are no major official changes in those areas: "this was a surprise relative to our expectation that the FOMC would add yield caps and targets to the toolkit in principle, but without expressing an intention to use them anytime soon."

So with the Fed's framework review wrapped up in line with expectations, Goldman now expects changes to the forward guidance and asset purchase program will come at the September FOMC meeting, versus its previous November expectations. That said, a delay until November remains possible in light of the "at some point" language in the minutes to the July FOMC meeting.