The annual Jackson Hole Symposium organised by the Kansas City Fed is one of the most awaited conferences on macroeconomics and central banking. The conference usually throws new ideas which are then debated in the media and academia for many years going forward. The 2020 conference was no different and perhaps, even more special given the surreal times.
This conference was highly anticipated as Federal Reserve chief Jerome Powell was going to announce the outcome of a two-year review of its monetary policy framework. In November 2018, the Federal Reserve instituted a review of its monetary policy framework for better achievement of its congressionally mandated goals of maximum employment and price stability. The Federal Reserve conducted different events around the country taking feedback via programmes such as Fed Listens (see my piece) and academic conferences.
Powell announced that the Federal Reserve will shift from inflation targeting (IT) to average inflation targeting (AIT). The Fed had adopted IT based on a review in 2012. Under IT, misses over inflation were treated as bygones but will not be possible under AIT. This can be explained via an example. The Federal Reserve targets inflation rate of 2 percent. Say actual inflation is at 1.5 percent for two years, then the Federal Reserve will ease policy rates and bring inflation back to 2 percent. However, this implies that the missed targets are not compensated in future policy.
Under AIT, Federal Reserve will have to maintain an average inflation target of 2 percent over a period. This would imply that if inflation was 1.5 percent for the last two years, then Federal Reserve will have to tolerate higher inflation of around 2.5 percent for the next two years to bring the average to 2 percent. This means bygones will no more be just bygones. Powell mentioned that they are not “tying themselves to a mathematical formula that defines the average”. This is a flexible form of AIT where if inflation and inflation expectations rise, then the Fed will not hesitate to act.
To be fair, it was expected that Federal Reserve will shift to AIT. On 24 August, Economists Stephen Chechetti and Kermit L. Schoenholtz wrote on their blog (https://www.moneyandbanking.com/) that the central bank is likely to adopt AIT. They quoted a Feb 2020 speech from Lael Brainard, one of the Governors on the Federal Reserve Board who said: “Flexible inflation averaging would bring some of the benefits of a formal average-inflation-targeting rule, but it could be more robust and simpler to communicate and implement.”
On the other dual goal of employment, Powell said that policy will be based on the "assessments of the shortfalls of employment from its maximum level rather than by deviations from its maximum level". This change in employment is rather subtle compared to the significant change in inflation. All it says is that mere deviations will not lead to changes in policy but the Fed will assess the shortfalls from the maximum level of employment. In the earlier times when the slope of the Philips curve was steeper, a rise in employment led to high inflation. The slope of Philips curve has flattened in today’s times and a rise in employment has not translated into higher inflation. This change in employment goal will calm markets that merely achieving maximum employment will not lead to an increase in policy rates.
What do both these changes imply? In simple words, it means Federal Reserve is likely to keep policy rates low for a much longer time than earlier expectations. The inflation has remained lower than 2 percent mostly since the 2012 review. Inflation has remained muted despite a decline in unemployment rate from 8 percent plus levels in 2012 to 3.5 percent levels in 2019 before the pandemic struck in 2020. Powell in his speech noted that “the historically strong labour market did not trigger a significant rise in inflation”. In fact, the unemployment rate has been lower than natural rate of unemployment levels of 4 percent.
As the Federal Reserve tries to average inflation at 2 percent and unemployment rates increase post the pandemic, the policy rates will remain low for an extended period of time.
What does this mean for other central banks such as RBI which also target inflation and is going to do a review next year? Will AIT work for RBI? Here is where the problems are.
An AIT approach implies that when inflation is high, policy rates will remain tighter for a longer period of time as well. Developing economies such as India suffer from higher inflation whereas in developed countries low inflation is a bigger concern, at least as of now. The central banks of developed countries are likely to look at this new Fed policy and may be take the same road (read my earlier piece).
Bernanke in a 2017 article had suggested an asymmetric approach: Central banks can use AIT type approaches in case of low inflation and switch to IT during high inflation. However, communicating such policies is rife with difficulties. Thus, it is unlikely that developing countries will opt for AIT. Moreover, India has a band of +/- 2 percentage points around the inflation target of 4 percent. This makes it even more difficult to practice AIT.
If there is something RBI could take from this Symposium it is to follow advice of Tiff Macklem, the Governor of the Bank of Canada. (Macklem interestingly last spoke at Jackson Hole in 2005 when there was an outbreak of SARS). He pointed the need for central banks to communicate and engage with public and not just MEN (Markets, Economists and News Agencies). Central banks are trying to support economic recovery and should explain their actions to people in a transparent and in a language free of jargon. Communications should also not just be about talking but listening as well. This is an advice definitely worth taking forward not just for RBI but central banks globally as well.
Amol Agrawal is faculty at Ahmedabad University. Views are personal.
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