Powell: Will reassess the "key components" of the 2020 monetary policy framework, long-term interest rates may rise.

Analysis suggests that this evaluation is unlikely to affect the way the Federal Reserve (FED) currently sets interest rates.

Written by: Bu Shuqing

Source: Wall Street Insight

In his speech on Thursday, Federal Reserve Chairman Powell clearly stated that they are reassessing the "key components" of their monetary policy framework, including the handling of the inflation target and the employment "gap." As the economy and policies continue to change, long-term interest rates may rise.

Powell stated that higher real Intrerest Rates might reflect the possibility of future inflation being more volatile than during the intermittent period of the 2010s, noting that "supply shocks" will be "more frequent and possibly more persistent," posing a difficult challenge for the economy and central banks. However, Wall Street Journal renowned reporter, Nick Timiraos of the "New Federal Reserve Communications" believes that this is actually not much related to the way The Federal Reserve (FED) is currently setting interest rates.

The 2020 framework is no longer applicable.

On Thursday local time, Powell stated at the Federal Reserve's Thomas Laubach ( research conference that the Federal Reserve is adjusting its monetary policy framework to respond to significant changes in inflation and interest rate outlooks since the pandemic in 2020.

He stated that the policy framework established in 2020 was based on the environment of persistently low Intrerest Rate and low inflation at that time, but current economic conditions have changed significantly.

We will ensure that the new consensus statement can adapt to a wide range of economic environments and developments.

It is particularly noteworthy that Powell clearly stated that "the zero lower bound constraint is no longer the baseline scenario." He indicated that after the pandemic in 2020, the inflation-adjusted "real" interest rates have risen, which may affect the elements of the current framework of The Federal Reserve (FED).

Higher real interest rates may reflect the possibility that inflation could be more unstable in the future than during the crisis period of the 2010s.

Reevaluating the Concept of "Gap": No Longer Overly Focused on Employment

The 2020 framework focuses the employment target of The Federal Reserve (FED) on the so-called "gap"—that is, periods when the unemployment rate is too high. This change effectively reduces the practice of the FED raising interest rates prematurely to cool the labor market and prevent inflationary pressures from arising.

Powell explained on Thursday that this adjustment does not represent a permanent abandonment of preventive policy measures or an oversight of the tight labor market conditions.

It indicates that the apparent tightness in the labor market alone is insufficient to trigger a policy response, unless the committee believes that without control, it will lead to undesirable inflationary pressures.

Rethinking the "Flexible Average Inflation Target"

After the framework review in 2020, the Federal Reserve adopted a "Flexible Average Inflation Target" approach, allowing inflation to moderately exceed 2% for a period after being below 2% for an extended time. Critics argue that this framework is too focused on the then-low interest rate and low inflation environment and is not suitable for the post-pandemic economic conditions.

In response, Powell stated in his speech:

In our discussion, participants have expressed that they believe it is appropriate to reconsider the wording regarding the "gap". In last week's meeting, we had a similar view on the average inflation target.

The rise in real Intrerest Rate may also reflect that future inflation could be more volatile than during the periods between the two crises of the 2010s.

Despite the framework being revised, Powell reaffirmed the importance of the 2% inflation target:

Anchoring expectations is crucial to everything we do, and today we remain fully committed to the 2% target.

Long-term Intrerest Rate may rise, 'supply shock' may become the new normal

Powell specifically warned:

We may be entering a period of more frequent and prolonged supply shocks — a daunting challenge for both the economy and central banks.

These remarks regarding "supply shocks" are similar to the warnings recently issued by Powell, who has mentioned multiple times that policy changes could put The Federal Reserve (FED) in a difficult balance between supporting employment and controlling inflation. Although Powell did not mention Trump's tariffs in today's speech, he has recently pointed out that tariffs could slow economic growth and raise inflation.

Powell also said that the framework review will focus on how it is communicated:

During periods of greater, more frequent, or more dispersed shocks, effective communication requires us to convey the uncertainty surrounding our understanding of the economy and its prospects.

Timiraos analysis believes that this assessment is unlikely to affect the way The Federal Reserve (FED) currently sets the Intrerest Rate. Powell stated that the new framework will be completed "in the coming months," which may mean he will outline this policy at the Federal Reserve's annual symposium held in Jackson Hole, Wyoming ).