Fed’s new strategy comes with big risks

After a more than year-long review of its monetary policy strategy, the Federal Reserve has decided it will throw away the rule book and let inflation run higher and unemployment run lower before seeking to tighten financial conditions. To be clear, this change leaves the central bank pursuing an almost completely discretionary monetary
policy, one where the risk is that the Fed fosters a more uncertain policy environment.
The Fed didn’t add any substance to their updated strategy — hopefully that will come later — leaving market participants somewhat adrift with respect to exactly what policy makers are trying to achieve. This lack of clarity may have been behind the rise in bond yields. It is reasonable to think yields will continue to drift higher until the Fed clarifies its intentions. Policy makers have long been moving in the direction of more discretion.
The old rules-based approach governing when to tighten and loosen monetary policy has fallen into disfavour as those rules were proven to be unreliable in times when economic conditions swiftly changed. In retrospect, a reliance on guides such the Taylor rule (which relates policy rates to output and inflation gaps) and the Phillips Curve (which relates inflation to unemployment rates) caused the Fed to over-predict inflation and set interest rates too high in 2018.
Even if the Fed could not rely on the old economic rules to guide policy, that guidance was still directed at sparking inflation toward the Fed’s 2% target. First implemented in 2012, the target still gave a sense of where the Fed wanted to go even if changing economic fundamentals made it less certain of how to get there. That changed, with Fed Chair Jerome Powell signalling that the central bank will tolerate an inflation rate above its 2% target by an unspecified magnitude for an unspecified period of time before tightening monetary policy. Not only is the economy adrift without policy rules, the Fed’s ultimate goal is no longer certain because it’s unclear what happens and when if inflation rises above the central bank’s target.
More specifically, the Fed formally adopted an average inflation targeting strategy in which it attempts to foster above target inflation to compensate of periods of below target inflation. Sounds straightforward, but the Fed made no shortage of caveats to the strategy:
In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time. Consider all the modifiers in that sentence, “likely,” “moderately,” and “some.” There is a lot of wiggle room there. Consider also Powell’s further explanation:
In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average.
—Bloomberg