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US Federal Reserve Announces Major Monetary Policy Shift at Jackson Hole Summit

Aug 28, 2020 1:07 PM 4 min read

Yesterday marked a historic turning point for US (and, by default, global) monetary policy.

Four decades since the Federal Reserve was shaped into an inflation-targeting institution, Fed Chairman Jerome Powell announced a tectonic policy shift.

This will remake how the central bank views its role in achieving maximum employment, ensuring price stability, and setting interest rates.

What’s the Fed’s new policy?

Under the new regime, the Fed may let interest rates remain low at the present near-zero levels for possibly years to come.

The long-standing practice of pre-emptively raising rates to stave off higher inflation has been dropped. Instead, the Fed will aim for “average inflation...moderately above 2% for some time”, renouncing the 2% inflation rate target it set for itself in 2012.

The new policy blueprint was announced by Powell via a virtual speech as part of the annual Jackson Hole economic summit of central bankers. This is usually held in Jackson Hole, Wyoming, but was conducted online this year, and was televised to the public for the first time.

The Fed still left itself some wriggle room, though. Powell didn’t clarify for how long the new regime would last or how high the central bank would let inflation rates climb. He also explicitly stated the new approach would not be dictated by any mathematical formula. More details could be revealed next month when the Federal Reserve is scheduled to have a policy meeting.


Why is the new policy a big deal?

The Wall Street Journal said the new policy “won’t lead to a significant change in how the Fed is currently conducting policy because it had already incorporated the changes it formally codified Thursday.” But broadly, it signifies a major reorientation.

The new approach places increased emphasis on the labour market and signals that the interventionist and accommodative stance the central bank assumed in recent months to address the coronavirus recession is likely to continue.

Such a posturing was widely expected and was long in the making. In 2018, confronted by a general economic downturn, Powell had initiated a wide-ranging policy-setting strategy review.

The chaos wreaked by the COVID-19 pandemic accelerated the probability of a repositioning. After all, the Fed now has to deal with low inflation (which it has been battling for years already), low economic growth, low interest rates and rising unemployment. All at the same time.

It is also important because the Fed’s U-turn might inspire similar policy changes by other central banks in the world. The era of inflation-targeting might very well come to an end.


What is “inflation-targeting”?

As the name suggests, it is the monetary policy wherein central banks explicitly aim for a stated inflation rate target. They do this primarily by increasing or decreasing interest rates.

Several major economies follow inflation-targeting. New Zealand, Canada and the UK were some of the first countries to adopt it as a policy objective. The US, as mentioned earlier, had aimed for a 2% inflation rate since 2012. And since 2016, the RBI has been required by law to target an inflation rate of 4%, allowing the same to fluctuate within the 2% to 6% band.

The pros of a rigid inflation-targeting system include relative price stability and better accountability from central banking institutions. But opponents of inflation-targeting argue that it is an inflexible target that offers limited guidance and could possibly constrict economic growth.

Criticism of inflation-targeting has steadily risen since the Great Recession. The pandemic has made the calls for a policy shift louder, and the Fed’s decision on Thursday could spark a domino effect.


Does the Fed’s new approach change anything for India vis-a-vis monetary policy?

The RBI has actively aimed for an inflation rate within the 2-6% bracket since 2016. Before that, a “multiple indicators” approach was followed, with inflation being only one of many metrics gauged by the Central Bank to fix the repo rate.

Critics have long held that singular fixation on the inflation rate has led to the RBI giving less importance to its other duties - like regulating the banking sector - and to other metrics - like wage growth and unemployment. They also contend that inflation-targeting has failed to even confine the inflation rate (CPI) within prescribed limits. Even before the pandemic, the rate had surged to a five-year high; and the situation has not improved since then.

The Central Bank has acknowledged the shortcomings of the current system. In February, Governor Shaktikanta Das had revealed that the RBI was reviewing the inflation-centred framework and “if required, we will have a dialogue with the Government”.

For some context: Just like its peers in many other countries, the RBI has been proactively intervening the past few months to support the economy. The measures implemented include repo rate cuts, loan moratoriums, loan restructuring programmes, Targeted Long-Term Repo Operations (TLTROs) and Operation Twist in the bond market.

We are living in unpredictable times, facing a once-in-a-century health crisis and a global recession worse than any since the Great Depression. So, a structural change in policy could very much be on the table.

As Tharman Shanmugaratnam, the head of the Monetary Authority of Singapore, told the Jackson Hole summit on Thursday:

We are not going back to a pre-COVID world.


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