A top Federal Reserve official on Monday defended a major shift in how the central bank sets interest rates by pointing to the failure of long-standing models to accurately predict the path of inflation.
Richard Clarida, vice chairman of the Federal Reserve, laid out the reasons why the bank broke with decades of tradition to adopt an inflation-averaging strategy that could result in interest rates staying lower for longer periods of time.
In a speech to the Peterson Institute in Washington, D.C., Clarida noted the link between inflation and the unemployment rate , known to economists as the Phillips Curve, began to lose its predictive power more than a decade ago. Even as unemployment declined to modern lows, inflation barely budged and remained surprisingly low.
As a result, the Fed repeatedly had to alter its economic forecasts and reduce its estimate of the so-called neutral interest rate well below its historical level. The neutral rate in theory reflects the interest rate at which inflation is neither rising nor falling.
The Fed’s new inflation-averaging strategy, he said, will give the central bank more flexibility to respond to inflation and not tie its hands, especially during times of economic crisis. Had the Fed strictly followed old models, he noted, the central bank would have raised interest rates when the economy was still weak and thereby harmed growth.
The Fed last week said it would now seek an average inflation rate of 2%, not a target of 2%.
Read:Here are the major changes to Fed’s strategy to foster jobs and stable inflation
While the change in language may seem minor, the result is that the Fed won’t necessarily raise interest rates simply because inflation rises to 2%. If inflation had averaged less than 2% for a long period, the Fed would be willing to let inflation rise above 2% for a while.
The adoption of inflation averaging marks a big shift in how the Fed seeks to approaches its dual mandate: To maintain stable inflation and maximize employment.
”Times change, as has the economic landscape, and our framework and strategy need to change as well,” Clarida said.
At the same time, though, the Fed has for now ruled out a pair of other controversial changes in its strategy. Clarida said the Fed still sees little benefit to negative interest rates or caps on interest rates. Yield caps would remain an option, he said, but only as a last resort.
When the central bank’s benchmark short-term fed funds rate is near zero, as it is now, Clarida said forward guidance and large purchases of Treasurys and other assets should be enough to support economic growth.
Forward guidance involves Fed officials publicly forecasting the level of interest rates and inflation a few years out to signal to investors the central bank’s intent. If the Fed signaled that inflation is likely to remain low for the next few years, for instance, investors, businesses and consumers could take it to mean that interest rates will also stay low.
