Yesterday, the Federal Reserve (Fed) announced it will be using a “flexible form of average inflation targeting.” Rather than maintaining its prior objective—to keep inflation below 2 percent—the Fed will aim for an average inflation level of around 2 percent. Now, inflation is well below 2 percent and has been for quite a while. So, markets have interpreted this announcement as the Fed saying it’s willing to let inflation run hot (i.e., above 2 percent) for some time to restore the average. And worries about hyperinflation have started to surface. I would argue, however, that what the new policy actually means is that rates will be low for a good long time.
Employment Vs. Inflation
The Fed is tasked with both keeping employment up and keeping inflation down. Typically, there has been a trade-off between the two, with high employment levels generating higher inflation, which required higher interest rates. Not this time.
Over the past decade, employment has boomed even as inflation stayed under control. Core inflation has been contained between 0 percent and 2.5 percent for the past decade, typically between 1.5 percent and 2.5 percent on a year-on-year basis. This containment has happened even as the unemployment rate dropped to 50-year lows and personal income and spending rose, driving demand for pretty much everything. The historical connection between employment levels and inflation has not appeared.
During that same period, the federal government was running substantial deficits, further juicing the economy. The Fed was doing the same with monetary policy, with historically low interest rates and other forms of monetary stimulus. Despite the economy running at full employment, as well as the tailwind from the Fed and the federal government, inflation still stayed under control. Inflation, even under boom conditions, simply has not shown up when expected.
Fed Paying Attention to Employment
Given the Fed’s statutory responsibilities, it has historically acted to forestall inflation when the economy heated up, even before it actually got going. All the announcement says is that, given current conditions, the Fed will now pay more attention to employment than inflation and will not act on inflation until there are unmistakable signs it needs to do so. In other words, until inflation actually rises above the target, the Fed will keep rates low. Based on the past decade, it will take quite a bit to make inflation take off. As such, we can expect rates to remain low for some time.
The conditions for higher inflation are certainly not in place. The unemployment rate is almost triple what it was, with millions still unemployed. While spending has held up, the recent expiration of the federal unemployment supplemental payments will take hundreds of billions of demand out of the economy going forward. And overall demand, even from those who have money, is still depressed by the pandemic. If inflation stayed under control with the unemployment rate at 3.5 percent, will it really rise at 10.2 percent?
This is the context in which the Fed just made its announcement. Yes, the Fed would really like to see inflation rise from the current low levels, but that has been largely the case for much of the past decade, and it hasn’t happened. Yes, the Fed would be willing to let inflation run hot, but it isn’t. And yes, the Fed will keep providing monetary stimulus, but that is precisely because demand is not strong enough to generate growth and inflation on its own.
Low Rates Ahead
In other words, the Fed is providing support because employment and the economy are weak, and the announcement is that it is more focused on providing that support than in fighting inflation. That makes sense, precisely because employment is so weak and there are no signs of inflation. In other words, what the Fed is saying is that it’s going to keep rates low because it doesn’t have to worry about inflation right now.
And neither do you.