Thursday 27 August 2020 4:04 pm

Fed to tolerate higher inflation in major policy shift

The US Federal Reserve has announced a new approach to monetary policy that will tolerate periods of higher inflation, paving the way for it to leave interest rates near record lows for the foreseeable future.

Fed chair Jay Powell announced the central bank would try to achieve inflation averaging two per cent over the longer run. Previously it had tried to get inflation to two per cent but not above that level.

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Under the new policy, the Fed will allow inflation to overshoot the two per cent mark for periods of time. It said this will counteract the stretches when it is below two per cent.

Powell also placed more emphasis on the Fed’s mandate of achieving maximum sustainable employment.

“Going forward, employment can run at or above real-time estimates of its maximum level without causing concern,” he said. Previously the Fed would have been more concerned about ‘overheating’ in the jobs market.

Powell said the change “reflects our view that a robust job market can be sustained without causing an outbreak of inflation”.

He said it also “reflects our appreciation for the benefits of a strong labour market, particularly for many in low- and moderate-income communities”. Many analysts took this to be a sign that the Fed was concerned about high unemployment in the black community.

Fed signals interest rates to be lower for longer

Analysts said the changes showed that the Fed plans to keep interest rates at record-low levels for years to come.

Bernd Weidensteiner, USA economist at Commerzbank, said the “shift towards a form of flexible inflation targeting and a greater tolerance for a hot-running labor market” meant “the Fed moves towards a looser policy setting over the long run”.

The Fed is now less likely to raise rates when inflation and employment levels rise. That means households and firms can expect rates to be lower for longer, encouraging lending.

US stocks rose as investors cheered the looser approach to monetary policy. The Dow Jones jumped 0.8 per cent and the S&P 500 climbed 0.3 per cent.

The dollar fell against a basket of currencies to trade close to two-year lows. Lower interest rates make the dollar less attractive.

Under Jay Powell, the Fed has intervened dramatically in the US economy during the coronavirus pandemic. It has pumped trillions into markets and slashed the key interest rate target to between zero and 0.25 per cent. 

The pandemic and record-low interest rates added impetus to the Fed’s monetary policy review, which was launched in 2018.

Rupert Thompson, chief investment officer at Kingswood, said the Fed’s move was “a bid to step up the effectiveness of its monetary policy”. He said policy had been “compromised now that rates are so low”.