UE-EN Institutional

The Fed’s new framework and its evolving reaction function

For investors, the implications are likely to be a more durable long-run “risk on” environment, a flatter yield curve and a depreciating dollar.
October 2020


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Amid an accelerating election season, ongoing pandemic and a return to partisan gridlock, the Federal Reserve (Fed) has been a bit less prominent in the news cycle lately. However, at the central bank’s annual August retreat in Jackson Hole, Chairman Jerome Powell announced amendments to the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy, which had been largely unchanged since 2012. At a recent mini-forum on this topic, we discussed the significance of this change and its implications for future Fed policy and for investors.

How did we get here?

For some perspective on this policy change, it is helpful to take a quick look back at the monetary policy environment of early 2019. From his predecessor Janet Yellen, Chairman Powell inherited a Federal Open Market Committee (FOMC) clearly tightening through higher rates and shrinking the balance sheet, policies the Powell Fed initially continued through 2018. However, many at the Fed had noticed sufficient changes in several structural features of the economy to call into question their near-term hawkish policy path and longer-run framework. First, the general level of interest rates had fallen close enough to zero to limit the ability of the FOMC to significantly reduce their policy rate in response to negative economic shocks. Second, inflation had consistently fallen short of the Fed’s own 2% target for an extended period.

PCE core inflation versus Fed target, 2012 – 2020

The feds new fremework

Source: U.S. Bureau of Economic Analysis, U.S. Federal Reserve.

Third, the level of unemployment consistent with the Fed’s mandate of full employment fell persistently after the financial crisis of 2008. Finally, the responsiveness of inflation to that level of unemployment had seemingly disappeared. A comprehensive review of the FOMC’s monetary policy framework was launched as a result. Taking a more dovish approach immediately, however, was complicated by the Fed’s tradition of incremental change and President Trump’s incursions into the usually politically neutral arena of monetary policy. In an effort to distance itself from this politicization, the Fed likely eased more slowly than perhaps Powell and others would have preferred, at least until COVID-19 cleared the way for dramatic interest rate cuts and aggressive expansion of the Fed’s balance sheet in 2020.

The Phillips curve is dead

With stubbornly low inflation tormenting the Fed during the Yellen years and into Powell’s tenure, it is not surprising that the principal element of the new policy featured in August was the targeting of an average rate of inflation over time, not a specific threshold value. The change to the Fed’s approach to unemployment, however, is just as important and deserves more attention. The Fed has effectively declared the Phillips curve dead, though it will still forecast the inputs. Going forward, policy decisions will be asymmetric, made according to shortfalls from maximum employment rather than a specific employment metric. Most tellingly, the Fed has been deliberately vague about what “maximum employment” means, underscoring the uncertainty around forecasting in today’s environment. This is an evolution of the Fed’s approach under Yellen, which was influenced by her background as a labor economist. In the years following the financial crisis, the Fed kept the faith that wages would rise at some point during the recovery as labor markets tightened, driving broader inflation higher. But as unemployment dropped steadily in the decade following the crisis, inflation failed to consistently push higher, countering the Phillips curve’s assumption of an inverse relationship between unemployment and inflation. In its new framework, the Fed has greater latitude to let the economy run hotter, leading some to quip that Powell has become “Yellen on steroids.”

PCE core inflation and unemployment in the 2010s

The feds new framework and its evolving reaction function pce core inflation and unemployment in the 2010s chart

Source: U.S. Bureau of Labor Statistics.

Powell differs from his predecessor in terms of inflation: the Yellen Fed tolerated inflation overshoots, but would not engineer them. Now, the Fed promises symmetry in future inflation around the 2% average target, but it has yet to be tested in real-world inflationary conditions. That inflation test should eventually come, given the Fed’s significant formal commitment to running the economy as hot as it possibly can until the price level accelerates.

The fork in the road

The Fed now faces a transition from recession-induced support to policy that reflects concerns about sustained low inflation, rates and growth. Although rates are low, asset purchases have continued and plenty of capacity remains in the liquidity and lending programs launched following COVID-19; Chairman Powell has continuously called for additional fiscal support from Congress. This makes the upcoming election vital to the policy mix. If President Trump wins and Republicans maintain their Senate majority, the result is likely to keep inflation at low levels. Republican skepticism regarding more fiscal stimulus will probably continue, barring another dramatic downturn in economic data during Trump’s second term. The status quo will likely render a similar outcome, with partisan gridlock keeping further stimulus under wraps and the U.S. economy undergoing a slow and uneven recovery.

If we see a Democratic majority in the Senate combined with a Biden win, fiscal policy is likely to be aggressive from day one, with infrastructure, education, child care and job training among the initiatives likely to be launched. The Fed will remain dovish as they believe these policies may help the economy reach the Fed’s twin mandates of maximum sustainable employment and price stability. The deficit, however, will expand further and inflation expectations may also rise, testing the Fed’s belief that expectations drive inflation more than the Phillips curve. The Fed may be pleased to take a backseat to fiscal policy, but higher inflation could bring the focus back to monetary policy. Though it seems unlikely today, a scenario with accelerating inflation and heavy debt burdens on government and households could require the kind of tough decision-making that Paul Volcker brought to the Fed in the late 1970s. While this would be a dramatic change from the current environment, the Fed has promised to remain adaptable in the short term, and its policy framework is reviewable every five years should a more significant course change become necessary in the future.

Implications for investors

The phrase “lower for longer” may seem headed for the discard pile with the Phillips curve. Some have joked that it should be replaced with “low rates forever.” For investors, the implications are likely to be a more durable long-run “risk on” environment, a flatter yield curve and a depreciating dollar. Asset bubbles may occur more frequently in this environment and contribute to greater volatility. However, the Fed’s new framework will only truly be tested later in the cycle when employment conditions tighten and the central bank must use this new policy framework and tools to contain inflation.


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