For much of its history, the Federal Reserve has moved quickly to raise interest rates at the slightest hint of inflation. The fear was that if unemployment fell too low, the economy would overheat, leading to runaway inflation. The approach seemed to work for much of the central bank’s history, but then something changed. Projections of rising inflation in the years since the 2008 financial crisis never materialized, even as unemployment fell past the point economists might expect to see it spike.
Last year, the Fed announced it was changing course. For years, the bank has set a target inflation rate of 2%. This remained the target even if the actual rate in previous years fell below that number. Now, the Fed will follow a policy of “average inflation targeting,” meaning it will allow inflation to rise above 2% following periods during which it has run below the objective. Fed Chairman Jerome Powell called the change a “robust updating” in a statement at the time.
“Our revised statement reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities, and that a robust job market can be sustained without causing an unwelcome increase in inflation,” he said.
According to William English, a professor in the practice of finance at Yale SOM and a former Fed official, the new policy reflects structural changes in the U.S. economy that have kept inflation lower than likely would’ve been the case 20 or 30 years ago. The change isn’t likely to transform the economy, he says, but it should help the Fed manage downturns and help stabilize unemployment, which has been much more volatile than inflation. “They’re shifting to an approach that should give them a little bit more volatile inflation and a little bit less volatile unemployment, and that they view that that as appropriate because the economy has changed,” he said. “Inflation is much more stable, inflation expectations are much more stable, and the zero bound is putting a constraint on policy.”
Graphics by Michelle Morgan.