The Fed goes one step further

Article about The Fed goes one step further

Sep 2, 2020

The dual mandate of the Fed

In 1913, the Federal Reserve System was set up in the United States in order to combat recurring financial crises more effectively. In the course of history, far-reaching events such as the Great Depression (the 1930s) and the Great Recession (2008–2009) contributed to the growing role of the Federal Reserve. In the Federal Reserve Act, Congress set three objectives for the central bank: maximising employment, price stabilisation and moderating long-term interest rates. The first two are often referred to as the Fed’s dual mandate. An important part of the mandate was also to maintain the purchasing power of the dollar.

Inflation remains low

For years, the main objective has been to achieve inflation of just under 2%. From 2015 onwards, increasing tightness on the labour market led the central bank to decide to increase interest rates step by step. Sooner or later, an upturn in the labour market should lead to higher inflation. In anticipation of this, the Fed raised interest rates. Globalisation, an ageing population and digitalisation had pushed inflation to historically low levels while unemployment continued to fall. It posed a dilemma for all central banks worldwide.

New strategy

At the end of last year, the Fed actually abandoned its decades-long policy. Although unemployment continued to fall, it lowered interest rates. After a strategic reorientation, the central bank publicly announced last week during a virtual version of the annual Jackson Hole meeting of central bankers that it would adopt a new strategy. The 2% inflation ceiling is being abandoned. From now on, the Fed will tolerate inflation above 2% in an upswing economy. Inflation may be above 2% at such times to compensate for lower inflation in less favourable times.

Low for a long time to come

In practice, the Fed’s adjustment will mean that interest rates will remain very low for a long time to come and will not be raised until a strong labour market ensures that inflation rises sharply. Thus, interest rates will not necessarily be raised when a situation of maximum employment is reached and inflation expectations increase, but only when there is actually higher inflation. A situation in which inflation has been below 2% for many years can thus turn into an inflation rate of more than 2%.

No increase in interest rates until 2024?

Since unemployment has risen very sharply as a result of the pandemic, the possibility cannot be ruled out that interest rates will remain low for years to come. The futures market does not even expect a rise in interest rates until 2024. The Fed thus runs the risk of losing control of inflation. Bankers once compared inflation with a tube of toothpaste. “Once out of the tube, you can’t get it back in”.

With this new strategy, the Fed says it will focus more on a healthy labour market. Powell stated that the US economy was in a very good condition before the outbreak of the virus. On the contrary, the Fed is now very concerned about high unemployment and its impact on ordinary Americans. It is very doubtful, however, whether the central bank will not use this new strategy to blow even more air into the stock markets. The long-term low-interest rates will mainly benefit those with a heavy debt burden (governments) and investors. Ordinary people are particularly affected when inflation rises. With this new strategy, the Fed suggests having full control over the level of inflation. However, the central bank seems to be suffering from a form of self overestimation. One of the objectives of the Federal Reserve Act — maintaining the purchasing power of the dollar — will thus come under further pressure. Anyway, since 1913, the dollar has already lost 96% of its original value..

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