The Federal Reserve has made a historic change to its goal of targeting 2% inflation, allowing for prices to temporarily rise above the threshold to make up for any time they spent below it.
The action marks a major shift to the Fed's decadeslong method of containing inflation, which has consisted of acting quickly to raise rates as soon as inflationary signs appear.
Fed officials will now likely keep interest rates lower for a longer period of time, as part of an effort to temporarily boost inflation past 2% to make up for periods when inflation was "running persistently below" their goal.
The new flexible average inflation targeting strategy will ensure that "undershoots of inflation are not forgotten," although any overshoots would be modest and not permanent, Fed Chairman Jerome Powell said at the Kansas City Fed's annual economic policy symposium.
Although they will remain cautious of any risks of too-high inflation, Fed officials learned after the 2007-09 financial crisis that the job market can run hotter than previously thought "without causing concern," Powell said.
"A robust job market can be sustained without causing an outbreak of inflation," Powell said at the event, which was held virtually due to the COVID-19 pandemic instead of at its usual mountain retreat in Jackson Hole, Wyo.
The speech underlines that the Fed will keep interest rates "lower for much longer," said Quincy Krosby, chief market strategist for Prudential Financial. The central bank slashed its benchmark federal funds rate to effectively 0% in March in response to the pandemic.
Stock markets were up slightly after Powell's speech, with the S&P 500 index rising 0.41% to 493.01 as of 11:25 a.m. ET. Meanwhile, bond yields shot up after the speech, with the yield on the benchmark 10-year Treasury rising to nearly 0.74% as of 11:30 a.m., up from about 0.69% on Aug. 26, according to Yahoo Finance.
The Fed's changes follow a broad review of the Fed's monetary policy tools that began in 2019, which focused partly on how low inflation limits central bankers' ammunition. It also focused on the recent breakdown in a key relationship that has guided central bankers for decades: Falling unemployment can lead to a wage-price spiral in which employers raise wages to compete for workers but also increase prices to potentially unhealthy levels.
That historical relationship did not hold up after the 2007-09 financial crisis. Inflation has remained stubbornly below 2% for much of the past decade even as the unemployment rate hovered around a 50-year low of 3.5% before the pandemic. The coronavirus outbreak has put further downward pressure on inflation due to disruptions in economic activity.
Inflation that is "persistently too low can pose serious risks to the economy," Powell said. It could cause households and businesses to ratchet down their inflation expectations and potentially lead to an "adverse cycle of ever-lower inflation" that would weigh on economic growth, he added.
Fed officials approved the changes to the Federal Open Market Committee's statement on its longer-run goals unanimously, though they had informally adopted the views that Powell laid out for months.
Although the changes had been well telegraphed, they still mark a major shift for a Fed that since the era of Chairman Paul Volcker has been known for fighting inflation, Krosby said.
"Now you have a Fed that hopes for inflation," she said, adding that the Fed will not raise rates until it is clear the labor market is "healthy and healing at all levels," particularly on the lower end of the income spectrum.
The Fed's new statement also says that its maximum employment goal is "broad-based and inclusive," a change that Powell said reflects a "clear takeaway" from the several community listening sessions it has held.
Fed officials consistently heard about the benefits a hot labor market brings to low-income and moderate-income communities, helping close longstanding disparities in racial inequality that the pandemic now appears to be worsening, Powell said.
He also said the central bank will undertake a similar broad review of its monetary policy tools and communications roughly every five years.
He also stressed that Fed officials are not "tying ourselves to a particular mathematical formula" that would bind them to a particular action on interest rates. That means the Fed's monetary policy actions "will continue to reflect a broad array of considerations," he said.
"If excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal, we would not hesitate to act," Powell said.