On August 22, the Federal Reserve released its revised Statement on Longer-Run Goals and Monetary Policy Strategy. The revised document reverses policy changes introduced in 2020 which some economists believe contributed to the surge of inflation in 2021 and 2022.
To understand the 2020 policy changes, we have to go back to earlier in the decade.
The Origins of the Federal Reserve’s Inflation Target
The Fed released its first policy statement in January 2012, part of a larger effort to make monetary policy more transparent. The initial policy statement was innovative in that it established, for the first time in the Fed’s history, an explicit inflation target.
The document stated that “…inflation at the rate of 2 per cent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the long run with the Federal Reserve’s statutory mandate.”
The primary goal of having a positive inflation target is twofold:
- It provides the Fed with a buffer against falling prices, reducing the risk of deflation. Deflation is a decline in prices that can disrupt the economy in many ways.
- To maintain higher short-term interest rates during stable economic periods, giving it more room to act when the economy slows.
The Fed’s primary policy instrument is the federal funds rate. Which is the rate that banks charge each other on overnight loans. When short-term rates are near zero, what economists call the effective lower bound (ELB). The Fed has little room to maneuver in the event of a slowdown or financial crisis. If the economy is stable, the Fed would prefer for rates to incorporate a 2% inflation premium.
Policy Shifts in 2020 and Their Impact
Throughout the 2010s, inflation and inflation expectations were running well below the Fed’s 2% target, leading many commentators to describe the “new normal” of low growth and low inflation.
By 2019, economic growth had accelerated, and the Fed was facing a paradox of tight labor market conditions and inflation below its 2% target. These conditions ran counter to economic orthodoxy, which states that tight labor conditions precede higher consumer prices. Meaning even though jobs were plentiful and unemployment was low, inflation remained subdued. Traditionally, a tight labor market signals rising wages and prices, but that expected increase didn’t materialize.
Against this backdrop, the Fed initiated a review of its 2012 policy statement. The findings of this review were released in August of 2020. The revised framework made two significant policy changes.
- The Fed would target 2% inflation “on average.” In other words, the Fed would accept higher than 2% inflation if inflation in previous periods fell short of its 2% target.
- The Fed would accept much lower unemployment before it viewed the economy as overheating.
Pandemic, Money Supply, and the Surge of Inflation
The timing of these revisions was not good. To battle the economic effects of the global pandemic, the Fed engaged in massive open market operations, spiking the money supply in the process. Below is a graph from the St. Louis Federal Reserve, showing M2 from 2016 to the present. M2 is a popular measure of the money supply, consisting of currency, checking and saving deposits, CDs, and money market accounts.
The shaded area represents the deep, but relatively short-lived, recession as the backdrop for the large increase in the money supply. Add to the increase in the money supply the effects of fiscal stimulus and production bottlenecks, and inflation was a likely result.
The Fed’s Response and a Return to Traditional Policy
Inflation began to significantly exceed the Fed’s 2% target in 2021. The Fed was slow to respond to the inflation. Chairman Powell and other Fed officials stating that the inflation was “transitory” and would subside as production bottlenecks opened. This came as a surprise to most Americans, who were paying higher prices for groceries, rents, and other staples of daily life.
The Fed began to respond in 2022 by sharply raising the federal funds rate. The tighter money conditions brought inflation down significantly from its 2022 high of over 7%, although at the time of this writing, inflation is still a bit above the Fed’s 2% target.
It is impossible to know if the changes made in 2020 would have been appropriate had the pandemic not uprooted the global economy. But for reasons beyond the impact of the pandemic, the “new normal” of the 2010s is probably over. In reverting back to a more traditional view, the Fed’s most recent policy changes reflect that reality.
Takeaways for Investors
The past several years highlight how quickly economic conditions can shift—and how central banks must adapt their strategies. Investors should remember:
- The Fed’s framework can change, but its long-term credibility depends on maintaining price stability.
- Surges in money supply and fiscal stimulus can amplify inflationary risks.
- Shifts in inflation expectations directly impact credit markets and investment opportunities.
For more insights on inflation and monetary policy follow the these links. As well as checking out my recent book recommendation Shock Values by Carola Binder. Get it today with my affiliate link!
