The Federal Reserve took a historic step on Thursday by approving a new policy that aims to stimulate higher inflation and lower unemployment more aggressively, a strategy that will likely keep interest rates low for years to come.
Traditionally, the Fed has taken a balanced approach, lowering interest rates to stimulate borrowing and economic activity to create lots of jobs, and raising rates when the economy was so hot it raised pressure. prospect of excessive inflation.
Now the Fed is effectively saying it will err on the side of job creation and not worry so much about spikes in inflation. Instead of always aiming for annual price hikes of 2%, the central bank will target average inflation of 2% over time. So if price hikes fall below the Fed’s target, as they have for most of the past decade, the Fed will leave inflation “moderately above 2% for a while. As Fed Chairman Jerome Powell said.
USA TODAY economics reporter Paul Davidson explains the Fed’s historic shift:
Why is the Fed taking this new approach?
Inflation remained below the Fed’s 2% target even as unemployment hit its lowest level in 50 years at 3.5% last February. Normally, a record unemployment rate should trigger higher inflation, as companies raise wages to attract a smaller pool of workers, forcing companies to raise prices to maintain profits. After the COVID-19 pandemic triggered the country’s most severe recession this year, inflation fell further while unemployment soared to 10.2%.
While the Fed has generally tried to avoid spikes in inflation, which weigh on Americans with higher costs, Fed officials have become more concerned about persistently low inflation. Low inflation can lead to lower prices, or deflation, which causes consumers to postpone their purchases as well as meager wage increases that particularly hurt lower and middle class Americans. Low inflation also causes the Fed to keep interest rates historically low, leaving it less leeway to cut rates in the event of a downturn.
As a result, the Fed has little to lose right now by keeping its key rate close to zero, which should theoretically help create more jobs, lower unemployment and allow inflation to soar.
The Fed is making a historic change:Fed announces historic policy change to boost inflation, job growth, and keep rates low for longer
Wasn’t the Fed already planning to keep rates close to zero?
Yes, but the new policy likely ensures that rates will stay at that level even if the economy reaches full employment and inflation exceeds the Fed’s 2% target in a few years. In the past, the Fed would likely have hiked rates in this scenario.
Who will benefit from the low rates?
Consumers and businesses have already taken advantage of low rates that lower borrowing costs for home and auto purchases, student loans, credit cards, and factory building, among others. The new policy will allow Americans to benefit from very low borrowing costs for even longer, even after the economy recovers.
Job seekers will also be among the winners, as low rates stimulate economic activity and hiring.
What about the stock market?
Low interest rates have already led investors to shift money from low-yielding bonds to stocks, helping to push the Standard & Poor’s 500 Index to new highs despite an economy still trying to break out of the water. ‘a brutal recession. The Fed’s wish to keep rates near zero longer amplified this effect, said Chris Zaccarelli, chief investment officer of the Independent Advisor Alliance.
Positive news about a COVID-19 vaccine or the economic recovery will weigh even more on the market, says Zaccarelli. But with low rates now even more entrenched, negative news can hurt the market but probably won’t bring stocks down, he says.
âThe Fed has put a floor under the market no matter what,â he said.
He adds: “Is there a risk that the Fed will create a (market) bubble” that will eventually burst?
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Who will be penalized by the Fed’s new strategy?
Savers, especially seniors, are the losers. After keeping its key rate close to zero for years after the Great Recession of 2007-09, the Fed gradually raised it in recent years, raising bank savings rates, especially for seniors with fixed incomes and less actions. But as the pandemic virtually shut down the U.S. economy, the Fed abruptly slashed rates to near zero in March, pushing savings returns again. Money market rates are on average well below 1%.
Will the Fed’s attempt to fuel inflation work?
It’s not clear. Rates have already been historically low, but inflation has been held back by long-term forces, such as discounted online shopping and a more globally connected economy. Add slower economic growth due to an aging population and anemic productivity gains. Keeping rates low for longer will not necessarily lead to more borrowing and economic activity.
“There is no guarantee that this will produce the expected inflation overrun,” said Michael Feroli, chief US economist at JP Morgan. “There is only so much (the Fed) can do.”