The Federal Reserve Thursday announced historic plans to change how it targets inflation, effectively allowing prices to run higher in order to accelerate growth and bring down unemployment.
Instead of targeting a 2 percent inflation level and raising rates to head off price pressure, Federal Reserve Chairman Jerome Powell said the central bank would aim for an average of 2 percent over time, which would let inflation briefly run higher.
With wage growth stagnant, higher inflation will increase the cost of everything from groceries to diapers and gasoline. Lower interest rates means credit cards, loans and mortgages are cheaper for households, but their bank savings will earn less in interest.
Powell said Thursday during a speech at the Kansas City Fed's 44th annual Economic Policy Symposium, this year being held virtually, that the push for greater inflation comes as the pandemic continues to impede economic activity. The Fed will refrain from raising interest rates until prices begin to increase.
The Fed has already taken drastic steps to counter the economic toll of the coronavirus pandemic and is expected to keep short-term interest rates near zero for the next five years. The September meeting will result in updated forecasts but Powell has repeatedly said the Fed isn’t considering raising rates.
During and after the 2007-2009 Great Recession, the Fed also kept rates near zero for several years. The current pandemic-related recession is far from over as much of America remains under strict social distancing guidelines and the economy continues to take a hit. Weekly initial jobless claims reported Thursday showed the unemployment recovery starting to plateau.
Powell's comments on Thursday were made ahead of September's Federal Open Market Committee meeting where the inflation framework changes are expected to be officially announced. Officials from the U.S. Federal Reserve have spent nearly two years reviewing the framework and trying to reach their goals of steady inflation and low unemployment.
Powell explained that the new flexible inflation target will account for unexpected changes and evolution.
"Following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time," Powell said.
That would mean the Fed might let inflation rise more than usual in order to keep the economy from being sluggish. This might also allow for lower unemployment because the Fed wouldn't be as prone to curtail employment growth out of fear that it will cause inflation to rise too quickly.
Instead of operating from the assumption that reaching a certain level of employment will cause inflation, the Fed will focus on specific areas of the job market.
“One of the clear messages we heard was that the strong labor market that prevailed before the pandemic was generating employment opportunities for many Americans who in the past had not found jobs readily available,” Powell said.
The central idea is that higher inflation would be a benefit to the public in the long run.
"The persistent undershoot of inflation from our 2 percent longer-run objective is a cause for concern. Many find it counterintuitive that the Fed would want to push up inflation," Powell said. "After all, low and stable inflation is essential for a well-functioning economy."
Powell said the Fed realizes that higher prices for essential goods such as food, gas and the cost of rent or a mortgage contribute to "the burdens faced by many families, especially those struggling with lost jobs and incomes." But he said inflation that's continually too low can present major risks to the economy, resulting in an adverse cycle of ever-lower inflation and inflation expectations," he said.
The expected changes come as unemployment has exploded to record high levels amid the ongoing pandemic.