By Howard Schneider
WASHINGTON (Reuters) -With mounting evidence that tight labor markets do not necessarily boost inflation and facing massive job losses in 2020, Federal Reserve Chair Jerome Powell oversaw a shift in U.S. central bank strategy that put more weight on the goal of full employment and pledged not to use a low jobless rate as a reason in itself to raise interest rates.
That tilt towards the labor market five years ago may have had little to do with the pandemic-era inflation that followed in 2021, but the Fed’s revised “framework” nevertheless appears headed for significant change amid mounting calls for a return to the sort of inflation-first central banking that Powell was eventually forced back towards as prices surged.
A two-day Fed conference beginning on Thursday in Washington will discuss current thinking about central bank strategy, with officials broadly acknowledging they need an approach “flexible enough so that any (Fed policy-setting) committee can do what it needs to do,” Cleveland Fed President Beth Hammack said in an interview with Reuters last week.
The language around employment may change; the promise of using higher inflation to offset periods of low inflation, considered confusing by many investors and intended as a fix to a problem that may prove to have been unique to the 2010-2020 period, may also be amended. Some nod to quicker inflation fighting is also possible.
“The conversation … is broad and open. … We’re looking at, in particular, the things that changed in that 2020 statement to see” whether those are appropriate to maintain, Hammack said. “What are sort of the risks right now in the economy and how do we set up a framework so that it neither ties a committee’s hands, but also sends a clear signal to the public” about how the Fed will react to different developments.
The revisions in 2020 are tied closely to Powell’s tenure. President Donald Trump is likely to appoint a new Fed chief when Powell’s term expires in about a year, winding down two consequential four-year terms in which he fended off precedent-busting insults from Trump, engineered massive central bank intervention to nurse the economy through the COVID-19 pandemic, and then resurrected the hawkish ethos of past central bankers to fight the worst inflation outbreak since the 1980s.
Along the way Powell oversaw the rewrite of Fed strategy. What seemed in the moment a compelling update based on how the economy had worked in the previous decade, the new approach quickly seemed out of step with where the U.S. was heading as the combination of trillions of dollars in federal fiscal support and tangled global supply chains led prices to spike.
As translated into its monetary policy statements at the time and coupled with other policies the Fed was using to battle the pandemic’s economic fallout, the framework arguably slowed the central bank’s response to the emerging inflation wave while policymakers waited to deliver on their commitment to restoring full employment.
There are disagreements over whether the delay in rate hikes ultimately mattered.
“This was an institutional failure of the first order. They said 2% and it was 10%,” said John Cochrane, an economist and senior fellow at Stanford University’s Hoover Institution, referring to the explosion of inflation beyond the Fed’s 2% target to above 9% in June 2022.
“I would like to see them say, ‘something went wrong, how do we do things differently?'” said Cochrane, an advocate of the Fed relying more on policy rules to at least guide the public’s understanding of how the central bank is likely to react to different circumstances.
But once the Fed did begin raising rates, it moved fast. The central bank delivered a historic round of 75-basis-point rate hikes in the summer of 2022 and stern comments by Powell over that summer made clear his intent to quell inflation even if it meant economic pain.
And inflation came down, largely without major disruptions to the economic recovery.
‘MUDDIED THE PICTURE’
Still, the episode raised questions about the Fed’s priorities and its communications. The minutes of the central bank’s March 18-19 meeting hinted at changes to come.
The minutes said staff presented estimates of how policy choices might change under the Fed’s current approach of only reacting to “shortfalls” from maximum employment – in other words only acting to support job growth, never to curb it as a possible inflation risk – versus reacting to “deviations,” a word that leaves open the possibility tight labor markets could raise inflation risks and warrant a rate increase.
There was attention to how the current language, describing maximum employment as a “broad and inclusive” goal, had been interpreted – a possible reference to both criticism among some elected officials that the Fed was delving into distributional issues, or to a sense that the employment language meant inflation had been deemphasized.
“Participants indicated that they thought it would be appropriate to reconsider the shortfalls language,” the minutes said.
Former Cleveland Fed President Loretta Mester wrote earlier this year that the lessons of the pandemic are that tight job markets can increase inflationary pressure, and the central bank’s policy-setting Federal Open Market Committee needs to put some weight on that possibility.
“The statement should … acknowledge that the FOMC uses indications from the labor market to help it forecast inflation,” wrote Mester, now a professor of finance at the University of Pennsylvania’s Wharton School.
The strategy document “should reinforce the forward-looking and pre-emptive nature of setting appropriate monetary policy,” Mester said, a call that others have echoed for the Fed to be more clearly ahead of the curve on prices.
Policymakers and staff involved in the effort, however, tend to downplay the framework’s role in how inflation unfolded and how the Fed reacted. The framework’s application may have fallen short, and Powell and others acknowledge they likely should have raised rates sooner.
But the basic approach remains sound, said Jon Faust, a former Powell adviser who is now a fellow at Johns Hopkins University’s Center for Financial Economics.
“The inflation we observed has muddied the picture about the framework revisions considerably. I don’t think the framework revisions played any role. I don’t think they deserve more than a footnote,” Faust said. “The employment revisions in particular – I hope the spirit remains; that we don’t take steps that would probably raise unemployment unless we see some risk on the other side.”
(Reporting by Howard Schneider; Editing by Paul Simao)
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