Federal Reserve Chair Jerome Powell used his speech to the KC Fed's Jackson Hole conference to signal changes to the Fed's policy approach. His speech gives a concise summary of the history of inflation targeting at the Fed, but one or two points deserve further emphasis.
First, the Fed was late to adopt formal inflation targeting, only taking its final step in that direction under the Chairmanship of Janet Yellen, less than a decade ago. Its earlier resistance to such a move can be blamed at least in part on Alan Greenspan. The wily and ultra-political "Maestro" never wanted to have his hands tied in any way. The Fed's inflation focus during his term in office was very much a moving target. Believing that the CPI overstated inflation pressures, Greenspan first shifted his attention to the previously obscure Employment Cost Index. When that no longer passed muster, he switched to the even more arcane core personal consumption expenditure deflator, a GDP-related figure that has the distinct disadvantage of being a quarterly number, rather than monthly like the CPI. This is not a sound approach to making policy.
Second, the Fed, unlike, say, the Bank of Canada, is already tasked with a dual mandate that calls on it to pay attention to both inflation and employment as it sets its policy course. It would perhaps be gratuitous to suggest here that under Greenspan, that seemed to expand to a triple mandate, with propping up the stock market becoming a central pre-occupation: the so-called "Greenspan Put". Leaving that aside, the dual mandate carries over into the changes that Chairman Powell announced this week. Here is how Powell described those changes:
Regarding employment: "Our revised statement says that our policy decision will be informed by our "assessments of the shortfalls of employment from its maximum level" rather than by "deviations from its maximum level" as in our previous statement. This change...reflects our view that a robust job market can be sustained without causing an outbreak of inflation. In earlier decades when the Phillips curve was steeper, inflation tended to rise noticeably in response to a strengthening labor market. It was sometimes appropriate for the Fed to tighten monetary policy as employment rose toward its estimated maximum level in order to stave off an unwelcome rise in inflation. The change to "shortfalls" clarifies that, going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals."
And regarding inflation: "our actions to achieve both sides of our dual mandate will be most effective if longer-term inflation expectations remain well anchored at 2 percent. However, if inflation runs below 2 percent following economic downturns but never moves above 2 percent even when the economy is strong, then, over time, inflation will average less than 2 percent. Households and businesses will come to expect this result, meaning that inflation expectations would tend to move below our inflation goal and pull realized inflation down. To prevent this outcome and the adverse dynamics that could ensue, our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time."
These are subtle shifts in wording, and as we move towards the post-COVID world, it may be quite some time before they result in any noticeable changes in the Fed's actual policy stance. However, they are an important recognition by the world's most important central bank that the old assumptions about a direct trade-off between inflation and employment no longer apply. For what it may be worth -- doubtless very little! -- I was never a fan of the Phillips curve that Powell refers to here. It looks as if it is about to join the Phlogiston Theory on the scrapheap of old ideas.
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