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New Fed Policy Allows Higher Inflation



Fed Policy

Stronger Job Market

The Federal Reserve announced a policy shift that will allow higher inflation for “some time.”  This, in turn, will support a stronger job market and sustain low unemployment. 

Fed Chairman Jerome Powell made the policy announcements during the Kansas City Fed's 44th annual Economic Policy Symposium yesterday. He said they will undertake a robust policy update involving “average inflation targeting.” While the Fed maintained inflation at 2%, they will now allow it to exceed the rate for some time. In contrast, the Fed opted to maintain inflation at a steady 2% earlier this year.  This means the agency will fight it when it runs too low instead of focusing on rising prices. 

RELATED: US Federal Reserve Makes Emergency Interest Rate Cut

Necessary Steps

Since March, the coronavirus pandemic has continued to wreak havoc on the economy. The reopening of the economy has slowed down as infection rates continue to stay high. Currently, the US owns almost 25% of total coronavirus cases, with deaths totaling 181,000. 

Earlier this year, the Fed intervened by cutting target interest rates to near zero. This aimed to contain the implosion of the market as almost all economic activities ground to a halt. The agency also set a target inflation rate at 2%. This is a monetary policy that sets a specific inflation rate as its goal. By making it seem that prices will increase, consumers buy now instead of later when items cost more. 

Now, the Fed will allow inflation to go over the 2% target before it considers raising interest rates.  This means that loan rates for businesses and individuals will stay low for the next few years. This also means that a more lenient approach to inflation can help sustain a stronger job market. While the preferred rate above 2% was not clear, Dallas Fed President Robert Kaplan suggested a range of 2.25%-2.5%.

Higher Inflation in the Long Term

Powell suggested that a higher inflation rate would be better long term. would be a benefit to the public in the long run. He said that the “persistent undershoot of inflation from our 2 percent longer-run objective is a cause for concern. Many find it counterintuitive that the Fed would want to push up inflation. After all, low and stable inflation is essential for a well-functioning economy.”

The Fed understands that higher prices of essential goods can burden struggling families. But, “inflation that's continually too low can present major risks to the economy, resulting in an adverse cycle of ever-lower inflation and inflation expectations,” he said.

Under the new policy, the pressure to keep interest rates low has gone away. This allows the Fed to continue with its stimulus programs to prop up the economy. 

The market welcomed the policy changes as it meant easy money is here to stay.  Stocks rallied higher, with the S&P 500 closing at a new record high 3484.55. 10-year Treasury bond yields rose from 0.686% to 0.744%. Powell expects the US recovery will continue, albeit with recurring stops and starts.” He also thinks that unemployment would stay elevated and that everything will depend on the improvement of the country’s coronavirus situation. 

The short version of the policy change simply means the Fed made sure its extraordinary stimulus measures, including low-interest rates, remain as is. These measures will stay there until the economy recovers and jobs get back.

Watch this as Jerome Powell on how the Fed decided to shift to ‘average inflation targeting' policy:

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