What effects will the Fed’s new average inflation target seek to achieve?

At the end of August, the Fed announced that it will have a different approach to inflation. In direct comparison to how the Fed has actively fought inflation in the past, it will now tolerate inflation when it rises above 2% for short amounts of time. In fact, they will look at target inflation in terms of averages. In practice, this may actually mean that they actively try to push inflation above 2% when thought necessary.

So how will the Fed’s new average inflation affect the US economy and the global economy as a whole? And why have the Fed chosen to change its approach to inflation? What effects does it seek to achieve in doing so? 

How The Fed’s New Average Target Inflation Could Affect The US Economy

It should not be dismissed or downplayed how substantial a shift the Fed has taken in its approach to inflation. While some may not see it as enough, by announcing that they are no longer following a policy that targets 2% inflation and instead will, at times , tolerate periods where inflation is above this, the Fed is demonstrating their want to accelerate economic growth. They are doing so by employing a method that has been actively avoided in the past. 

However, will it be effective? Or, indeed, can it be effective when interest rates are so low? What exactly is the Fed trying to achieve by amending their approach in this way? Cynics will argue that some of this action will be a direct response to negative commentary lamenting the Fed’s very inaction in recessions of the past. 

But beyond that, Jerome Powell’s announcement can be viewed as one asserting the Fed’s wish to help achieve full employment within the economy. The Fed’s average inflation target will hopefully give the Reserve the freedom with which to move to attain improved employment rates. As a result, many commentators claim that we can expect the Fed to actively target inflation rates much, much higher than 2% in an effort to kickstart elements of the economy that will in turn produce job growth. 

Importantly, the markets can also determine from this announcement that the Fed does not want to enter the remit of negative interest rate. This was also an option, but one that they chose to eschew in favour of chasing higher inflation instead. Additionally, it is perhaps an admittance that the huge financial stimulus packages that they have delivered so far this year, may not be enough to support the economy and its recovery. We have also seen many disinflationary forces in play during the pandemic including low productivity and continued, persistent unemployment. 

What Can We Expect From The Fed’s Changed Approach To Inflation Targeting

So what can we expect in practice from the Fed’s changed approach to inflation targeting? We can learn a lot simply from the intention of the Fed’s changed approach – even if an average 2% is not achieved. Firstly, it shows that the Fed is comfortable with maintaining unprecedented levels of stimulus in the face of the pandemic. The fact that markets reacted positively to the announcement shows that this flexible monetary policy is viewed as a good thing. Secondly, the Fed and Jerome Powell were noticeably vague in what they considered to be an inflation rate too high which would trigger tightening of monetary policy. 

The announcement was not without its detractors however – despite the markets reacting positively to the news. Some say that the wrong sort of inflation may be achieved due to the drivers that help reach those higher inflation rates. For example, supply shortages and higher costs will drive up prices as opposed to inflationary forces coming from positive demand. Additionally, high unemployment in the US will mean there is low wage acceleration which is needed as a major driver behind inflation. 

However, ultimately, the Fed is arguably targeting higher inflation to help tackle the high unemployment rates in the US. Additionally, it gives the Fed the ability to maintain low rates which is essential to help support riskier assets, both domestically and internationally. In doing, equity markets have the ability to achieve new highs and help fuel growth both in the US and beyond.