(Bloomberg Opinion) -- The minutes of the Federal Reserve’s monetary policy meeting in January that were released Wednesday show central bankers continue to move closer to explicitly allowing the economy to run hot enough to push the inflation rate above its 2% target for a period of time. The big undecided question is, will the Fed lower interest rates to meet this new objective? While a rate cut looks to be the logical conclusion of the Fed’s policy review — and is what the market expects -- it may still decide it can achieve higher inflation without lowering rates.
The minutes emphasized the Fed’s concerns about slow inflation. While meeting participants generally believed current policy would guide inflation back to 2%, “several” thought inflation “modestly exceeding” 2% would be consistent with the stated inflation policy and strengthen the symmetric nature of the Fed’s target. Similarly, the minutes revealed that the Fed altered the statement released at the end of the January meeting to describe policy as appropriate for inflation “returning to” target rather than just “near” in order to signal officials were not pleased with the persistent undershooting of the target. In addition, the Fed staff noted that survey-based measures of inflation expectations were near record lows.
The upshot is that the Fed remains concerned about persistently slow inflation and would like to see modestly above target inflation. Still, the framework and communications strategy need to change for the Fed to foster a rate of inflation that is above its target. The Fed looks to be moving toward some form of an average inflation targeting framework that would explicitly use above-target inflation to make up for past inflation shortfalls. At the January meeting, policy makers worked on changes to their communications that could support such a policy framework.
The Fed staff presented three options for communicating an inflation range. The first was an uncertainty range to highlight the natural variability of inflation. The second was an operational range to signal that inflation would deviate from target for a period of time. The third was an indifference range in which the Fed would not respond to inflation.
Participants expressed discomfort with the uncertainty range as it could imply that they were fine with inflation running persistently below 2%. This might then make an uncertainty range appear the same as an indifference range. Other participants thought an uncertainty range might further confuse the public and make the 2% objective less clear.
Several participants, however, saw benefits in adopting an asymmetric operational range with 2% at or near the bottom of that range. This would allow the Fed to guide inflation above 2% temporarily to achieve their target over time. The staff specifically identified an operational range as consistent with a strategy like average inflation targeting.
So while the details are still in flux, the direction of the policy review continues to move the Fed toward taking a more aggressive stance with respect to meeting its inflation target in a symmetric fashion. Logically, this implies the Fed will cut rates after their policy review, and this has become a dominant narrative among market participants.
There are two points to consider, though. The first is that easier policy does not have to take the form of a rate cut. It could take the form of a lower path of future policy rates in the Summary of Economic projections. Just pull out the forecasted 2021 rate hike.
Second, policy is always data dependent. Participants appeared fairly optimistic in January. While they recognized that downside risks remained, they also saw the balance of risks as having shifted in a more favorable direction since their December meeting. To be sure, the coronavirus threat was still new. But on the other hand, the improvement in the housing market suggests the U.S. economy may have more momentum than they thought. If they have more faith that the economy will accelerate to above trend growth after the policy review, they could easily decide another rate cut was unnecessary.
The Fed appears on hold for the near term while the policy review and coronavirus leave the balance of risks tilted toward easier policy later in the year. Still, we shouldn’t count on that just yet. It’s still far enough out that the Fed might not feel compelled to push back on market expectations. We should be wary that they decide to push back as they come closer to announcing the outcomes of the policy review.
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Tim Duy is a professor of practice and senior director of the Oregon Economic Forum at the University of Oregon and the author of Tim Duy's Fed Watch.
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