Federal Reserve Chair Jerome Powell delivered his much-awaited speech in which he unveiled the outcome of the Fed’s strategy and communications review. As expected, the Fed adopted a policy of average inflation targeting. There, however, was a twist. Powell describes the policy as “flexible” inflation targeting, meaning that it lacks specificity beyond a general intention to compensate for periods of undershooting the inflation target. That lack of specificity makes it a Fed watcher’s dream as it opens up range of possible policy objectives that may shift over time.

Much of the ground Powell covered would sound familiar to someone following the Fed throughout this process. The last decade has challenged the Fed’s operating framework with a falling natural rate of inflation, policy rates near the zero bound, a weakened relationship between unemployment and inflation, questionable estimates of the natural rate of unemployment, and a heightened awareness of the cost of unemployment, particularly as the costs relate to disadvantaged persons. Powell does very good job of running through the history and the motivation for the review; it will make a nice addition to my syllabus this fall.

As a result of this process, the Fed made four innovations to the strategy statement:

1. The Fed identified the zero bound problem as constraint on policy: A lower neutral real rate translates into policy rates sufficiently close to the zero bound that the Fed will more often face the zero bound constraint when attempting to stimulate the economy. The creates a downward bias in the risks to the economy. As a consequence, the Fed is “prepared to use its full range of tools to achieve its maximum employment and price stability goals.” In other words, the Fed will continue to heavily rely on tools such as forward guidance and asset purchases. The persistence of the downside risks means that they will bring these tools to bear more quickly.
2. The importance of employment is elevated over inflation: The Fed now describes the goal of maximum employment as “a broad-based and inclusive goal.” The Fed explicitly recognizes that a focus on headline inflation fails to account for higher unemployment among disadvantaged populations. To benefit everyone, the headline unemployment rate needs to be pulled lower than previously though compatible with full employment (in practice, the Fed uses a broad array of labor indicators in forming this assessment). The Fed also added that policy decisions will be “informed by assessments of the shortfalls of employment from its maximum level.” This replaces “deviations from maximum employment” language. “Deviations” is two-sided, “shortfalls” is one-sided. In practical terms, low unemployment itself no longer justifies tighter policy when in the absence of clear inflationary pressures.
3. Average inflation targeting: Under the previous framework, the Fed did not attempt to compensate for undershooting the inflation target. As a consequence, the Fed appeared to be treating the 2% inflation target as a ceiling in that they tightened policy to preemptively prevent inflation from rising above 2%. The end result was inflation persistently below 2%, an outcome that may have contributed to softening inflation expectations. Now the policy allows for overshooting:
   

   In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.

4. An increased focus on a stable financial system: Powell and others have frequently cited the role of financial sector imbalances in recent cycles and this fact likely heightened some concern among FOMC participants that a persistently low interest rate policy would lead to fresh imbalances that would threaten the economy. To recognize this, the Fed added this language:
   

   Moreover, sustainably achieving maximum employment and price stability depends on a stable financial system. Therefore, the Committee’s policy decisions reflect its longer-run goals, its medium-term outlook, and its assessments of the balance of risks, including risks to the financial system that could impede the attainment of the Committee’s goals.

This opens up the possibility of rate hikes to quell financial excess, although this remains a focus for only a minority of FOMC participants.

All well and good. Now here is the bad news: You can drive a truck through the holes in the average inflation targeting policy. It averages over an unspecified time, it only will “likely” aim to achieve “moderate” inflation again for an unspecified amount of time. As Powell further explained:

In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average. Thus, our approach could be viewed as a flexible form of average inflation targeting.

I do enjoy that we can’t define the “average.” It sounds like the policy was written by a committee, which it of course was, and as such it likely has a different interpretation to each committee member. It is a Fed watcher’s dream come true.

At this point, the practical implication of the policy change is that they intend to maintain an accommodative policy stance until inflation at a minimum reaches 2%. Beyond that though, there is as of yet no meat on the bones of this policy. We do not know how much inflation the Fed is willing to tolerate and for how long. We do not know under what conditions they are willing to ease policy further. We do not know how long they will tolerate the long end of the yield curve drifting higher. In short, we are still waiting for operational guidance to support the new policy.

As of the July FOMC meeting, participants appeared to not have reached any sort of agreement on next steps:

With regard to the outlook for monetary policy beyond this meeting, a number of participants noted that providing greater clarity regarding the likely path of the target range for the federal funds rate would be appropriate at some point. Concerning the possible form that revised policy communications might take, these participants commented on outcome-based forward guidance—under which the Committee would undertake to maintain the current target range for the federal funds rate at least until one or more specified economic outcomes was achieved—and also touched on calendar-based forward guidance—under which the current target range would be maintained at least until a particular calendar date. In the context of outcome-based forward guidance, various participants mentioned using thresholds calibrated to inflation outcomes, unemployment rate outcomes, or combinations of the two, as well as combinations with calendar-based guidance. In addition, many participants commented that it might become appropriate to frame communications regarding the Committee’s ongoing asset purchases more in terms of their role in fostering accommodative financial conditions and supporting economic recovery.

Nor did it seem like they would focus on the issue until the strategy review was complete:

More broadly, in discussing the policy outlook, a number of participants observed that completing a revised Statement on Longer-Run Goals and Monetary Policy Strategy would be very helpful in providing an overarching framework that would help guide the Committee’s future policy actions and communications.

I don’t know that they have time to move on to operationalizing the new policy prior to the next meeting, which means the market participants may remain in the dark about the exact implementation of average inflation targeting.

Bottom Line: The Fed formalized the outcome of its policy review and left little doubt that they intended to pursue a more dovish policy path than in the last expansion. They have, however, provided few operational details. The average inflation targeting described so far looks less like a commitment to achieving an average of 2% inflation and instead just provides room to allow inflation temporarily to rise a notch above 2%. Interestingly, the lack of specificity leaves them less vulnerable to claims they aren’t meeting their target. Who knows what it is? More information is needed; look for Fed speakers for clarity. Hopefully.