Since the relationship has broken down as shown in Figure 1, the Fed has now tuned its focus more towards inflation alone. The Fed’s new approach is that it is highly desirable to have an inflation rate of at least 2%, and that it is willing to let inflation run hotter than that “for some time”. The reasoning is that by setting an inflation target, businesses and consumers will expect inflation to rise and so will contribute to that rise. Without a target, businesses and consumers might expect inflation to fall, which in turn would drive interest rates down, and leave central bankers with very little ammunition to fight a recession. The Fed’s policy rate is currently 0% - 0.25% and was also in that range for seven years after the Great Recession in order to stimulate the economy, yet the resulting drop in unemployment failed to produce inflation. If inflation and inflationary expectations continue to drop, interest rates would drop even further, and the Fed would be helpless to boost the economy by lowering interest rates.
A change from prior language was significant, saying that the evaluation of the labor market would be informed by “assessments of the shortfalls of employment from its maximum level” – previous wording referred to “deviations” from the maximum level. Powell specifically noted the change in language, saying “This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities.” “This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.”
The practical result of the change to “inflation targeting” is that short-term interest rates are likely to stay lower for longer, now based on the operating presumption that they can do so without causing inflation, while boosting the labor market. Long-term interest rates, however, may be pressured upwards as inflationary expectations and inflation rise. A somewhat incidental consequence would be a steepening yield curve, typically a harbinger of a recovering economy.