Last Thursday, Federal Reserve Chairman Jerome Powell’s comments helped bolster stock prices. Powell replaced the bank’s existing target for inflation of 2%. Instead, they would accept an average of 2%, and therefore allow price increases above 2% for some time period.
Former Federal Reserve Chairman Ben Bernanke said, “They believe, and I agree, that there are substantial social benefits from a strong labor market. They will not take any steps to cool the labor market unless there is clear evidence of inflationary pressure.”
All three stock indices are positive for 2020. The shift to online shopping has boosted winners. By contrast, brick and mortar stores have witnessed a collapse in revenue.
Record low mortgage rates have pumped up housing prices and housing stocks. Higher home prices suggest that part of the economy is healing.
Creditworthy companies have been able to borrow very cheaply. By contrast, many junk borrowers have paid higher rates than before the crisis.
In response to high inflation in the 1960s and ’70s, Congress amended the Federal Reserve Act. Specifically, the Fed added to its historic focus on maximum employment by including stable prices. Under its current operating philosophy, the Fed no longer emphasizes controlling inflation.
The abandonment of restricting price increases is currently insignificant because inflation remains low and unemployment is approaching 11%.
Until recently, economists endorsed the validity of the Phillips curve. This theory claims that with economic growth comes inflation. Higher inflation is associated with lower unemployment and a stronger economy and vice versa.
Central bankers now believe that unemployment can be too high, but never too low. Since 1998, with one small exception in 2018, the inflation rate has been below 2%. Therefore, the Fed believes we can enjoy a robust job market without risking an outbreak of inflation.
Global competition has reduced the threat of inflation. Because many of our trading partners suffer from low growth and low inflation they can provide us goods and services cheaper than domestic sources.
Historically, the Fed has been able to fight recessions with its ability to cut overnight loans between banks (the federal funds rate). However, if interest rates are already low, then further reductions have no meaningful consequences.
Since 2007, the Fed has added two tools to support the economy. Namely, the Fed began making large-scale purchases of longer-maturity Treasury and mortgage securities (quantitative easing) and communicated its intentions for short-term interest rates (forward guidance).
On the other hand, we have not undertaken several policies of other central banks. Specifically, we have not:
1. Pursued negative interest rates.
2. Targeted rates on longer-maturity securities by committing them to purchase bonds at predetermined prices (yield-curve control).
In recent years, the Federal Reserve has been criticized for lack of clarity in communicating its policies. John Taylor, a Stanford University economist, encouraged the Fed to specify how it would act under various circumstances to provide more certainty to households, businesses and financial markets.
To improve communication with the public the Fed recently instituted the following steps. Specifically, it hosted a research conference in Chicago, hosted 12 Fed Listen events at each one of the Federal Reserve Banks, and held two events in Washington, D.C. It invited representatives of business and industry, small business owners, entrepreneurs, labor leaders, nonprofit organization executives, etc.
The current environment of low inflation and high unemployment prevents real world examination of the Fed’s wisdom of abandoning previous central bank concerns over inflation. From the mid-’60s until the mid-’80s, inflation caused major challenges. In the ’80s, Fed Chairman Paul Volcker imposed overnight rates above 20% to break the back of inflation. For many years we celebrated his courage and benefited from his policy prescriptions. Fortunately, we can institute Volcker’s tough love policies if conditions warrant it.
