At the United States Federal Reserve's annual Jackson Hole symposium on Aug 27, its chairman Jerome Powell announced a significant change in the way the Fed will conduct monetary policy in the future. Essentially, it will switch from targeting a fixed rate of 2 per cent inflation to targeting an average rate at that level. This means, for example, that if inflation undershoots 2 per cent by, say, 50 basis points for six months, the Fed will tolerate an inflation rate of 2.5 per cent for six months, without raising interest rates as it might have done in the past. It will also depart from its usual practice of pre-emptively raising rates in anticipation of higher inflation if unemployment approaches "full employment" levels. The upshot of all this is that US interest rates, currently near zero, will remain lower maybe for some years.
This has major implications for the US and the global economy, given that the Covid-19 pandemic has significantly altered how consumers and businesses behave. The reasons for the Fed's policy pivot are understandable. Ever since it adopted its 2 per cent inflation target in 2012, it has consistently failed to achieve it. In the aftermath of the pandemic, ultra-low inflation is especially problematic because it would mean that the burden of corporate, household and government debts - which are already rising - would increase in real terms. Consumption could also go down if expectations of low inflation become entrenched, which would jeopardise the economic recovery.