trending Market Intelligence /marketintelligence/en/news-insights/trending/wYX52QN971mNaCMURw3MQA2 content esgSubNav
In This List

Fed weighs rethinking inflation strategies to bolster recession toolbox


Deep Market Intelligence Helps a Credit Union Craft a Successful Expansion Plan


Global M&A By the Numbers: Q1 2022


Investment Banking Essentials Newsletter April Edition - 2022


Banking Essentials Newsletter April Edition - 2022

Fed weighs rethinking inflation strategies to bolster recession toolbox

Federal Reserve officials are weighing whether a low-inflation world gives them enough ammunition to combat the next recession and whether a new position on their inflation target is warranted.

The Fed, like other major central banks, is grappling with the "new normal" of an aging population and other longer-term factors that have pushed down interest rates globally.

The trend poses a major dilemma for the Fed during the next downturn, when the central bank will have less room to provide stimulus by cutting short-term interest rates. Instead, the Fed will be much more likely to cut rates to near-zero levels again and consider more drastic measures beyond that, such as its crisis-era quantitative easing purchases or perhaps even experimenting with negative interest rates.

SNL Image

The Fed wants to avoid those scenarios, and letting inflation go above the current 2% target would help officials do that to some extent, economists say. But doing so could be a tricky endeavor, potentially leading to confusion if the Fed does not adequately communicate changes to its inflation strategy.

"If they really want to impact inflation expectations, [it] can't be totally done behind a veil, behind a wall of PhD-speak," said Lara Rhame, chief U.S. economist at FS Investments. "If they want to impact markets, they have to actually communicate it in the right way."

Any changes from the Fed are likely to take months as policymakers weigh the pros and cons of their current strategy to achieve 2% inflation. The central bank will host a research conference in Chicago in early June as part of a monthslong review of its monetary policy framework and will share its conclusions in the first half of 2020.

Fed officials have already ruled out raising their inflation target to perhaps 3% or 4%. Fed Chairman Jerome Powell told House members in February a higher inflation target is not an option and that officials are only considering ways to "more credibly achieve" the existing 2% goal.

It is possible that the review will not lead to any changes to the Fed's current inflation regime, which Powell has said has "served the public very well."

Inflation has generally been below 2% since the central bank explicitly set the goal in 2012. After reaching the 2% mark several times last year, the Fed's favored gauge has dipped recently and rose 1.6% year over year in March.

Some Fed officials worry that inflation could be at risk of being stuck below 2%, particularly if the public believes officials view 2% as a ceiling the Fed is unwilling to cross.

SNL Image

Those worries — and Japan's ongoing struggles to break out of a similar cycle — have fueled talk and research papers over whether the Fed should switch to alternative methods of targeting inflation, such as price-level targeting or average inflation targeting.

Those policies would imply a more dovish policy from the Fed, calling on the Fed to keep interest rates "lower for longer" so that they can engineer an overshoot in inflation to make up for past misses on the downside of the 2% target.

Under price-level targeting, for example, the Fed would aim to get growth in the overall price level back to the desired trend — compensating for a shock, such as a recession, that could hold prices down and veer them away from the trend.

Under its current strategy, the Fed does not explicitly compensate for past misses in its target.

Economists both inside and outside the Fed have found that those inflation make-up strategies may be more effective in anchoring inflation expectations around the 2% target. But major central banks' experience with those strategies is limited, with their benefits largely described in academic models that automatically assume markets and the public fully understand the Fed's commitment to make up for inflation misses.

Whether the Fed could achieve those benefits in practice is "one of the most challenging questions" officials will consider, Fed Vice Chairman Richard Clarida, who is leading the review process, said in February.

Some Fed officials are also skeptical that a change is necessary at all, with Fed Vice Chairman for Supervision Randal Quarles saying he would avoid "heroic efforts" to reach 2% if inflation is only underperforming that mark slightly.

But even if they opt for no changes, several Fed officials are already making it "loud and clear" that they would tolerate a modest overshoot in inflation without seeing an urgency to raise rates again, said David Page, senior economist at AXA Investment Managers. That more implicit promise of an overshoot may end up being the option that the Powell-led Fed chooses, he said.

"I think he will adopt a much more pragmatic solution," Page said. "That seems to be what the Fed is doing now, where it talks about wanting to encourage a symmetric target and I think implicitly allowing an overshoot."