In early 2019, the Federal Open Market Committee (FOMC) began its first-ever public review of its monetary policy framework, assessing what strategy and tools would best support the Fed’s congressional mandate of achieving long-term price stability and maximum employment. A year and a half later, the Fed released its revised “Statement on Longer-Run Goals and Monetary Policy Strategy” (often referred to as the “consensus statement”), which serves as the foundation for the Fed’s policy actions. This paper will discuss the evolution of monetary policy, key economic developments, the Phillips curve, the Fed’s new framework, and the implications for commercial real estate and the overall economy.
Evolution of Monetary Policy
At the start of the century, many central banks implemented or had implemented inflation targeting. Within this monetary policy framework, the primary objective was to reach an annual inflation goal of 2%, while clarifying the central bank’s intentions through increased transparency and communication with the public. Under Ben Bernanke’s leadership, the Fed adopted many of the components associated with “flexible” inflation targeting by taking into account economic stabilization, in addition to an inflation objective.
During that time, Janet Yellen headed an effort to codify the FOMC’s approach to monetary policy. In January 2012, the first “Statement on Longer-Run Goals and Monetary Policy Strategy” was published, articulating the longer-run inflation target of 2%. The consensus statement was a considerable milestone, illustrating lessons learned from combatting high inflation and from other central banks’ experience with flexible inflation targeting.
Key Economic Developments
Since 2012, four key economic developments have arisen, motivating the Fed to review its eight-year-old consensus statement. First, the median estimate of the longer-run growth rate of the economy has declined from 2.5% in 2012 to 1.8%, currently. Given the ageing population and declining population growth, some slowing in real gross domestic product (GDP) gains, relative to past decades was expected. However, a more troubling trend, declining productivity growth, has emerged threatening the improvement of living standards over time.
Second, interest rates have fallen across the globe. The neutral federal funds rate, which is consistent with long-term price stability and maximum employment, has declined substantially, indicating a drop in the equilibrium real interest rate (r-star). Driven by fundamental elements of economic activity, such as productivity growth and demographics, r-star has been unaffected by monetary policy. The FOMC’s median estimate of the neutral fed funds rate dropped to 2.5% from 4.25% eight years ago. The decline in neutral rates increases the risk that the federal funds rate will drop to or below its effective lower bound, limiting the central bank’s ability to backstop the economy through further rate cuts.
Third, the record-setting economic expansion that concluded in early-2020 resulted in the greatest labor market in decades. In February 2020, the month before covid was recognized as a pandemic, U.S. unemployment was at 3.5% – the lowest in roughly 50 years. Fourth, the historically robust labor market did not produce a significant growth in inflation, challenging a core economic belief known as the Phillips curve, which illustrates the inverse correlation between unemployment and inflation.
The Phillips Curve
The lack of inflation’s responsiveness to a tight labor market has resulted in a flattening of the Phillips curve, calling back into question the viability of this economic principle. In 1958, William Phillips conducted a “quick and dirty” study chronicling a striking, decades-long negative correlation between unemployment and inflation, resulting in a downward-sloping curve. Since then, the Phillips curve, as it became known, has been both praised as “the single most important macroeconomic relationship” and condemned as the “least solid piece of work” Mr. Phillips ever created. Nonetheless, the Phillips curve still influences central bank policy to this day.
In the 1960s, renowned economist, Milton Friedman, discovered that the correlation between inflation and employment is only as relevant as its underlying assumptions. Longer-term inflation expectations have always been a significant driver of actual inflation. In the 1970s, high inflation prevailed despite growing unemployment due precisely to workers’ expectation of rising inflation. Following this period, economists began to augment the Phillips curve by including expectations, alongside unemployment as a separate cause of inflation.
The Danger of Persistently Low Inflation
While many may find it counterintuitive that the Fed wants to increase inflation, consistently low inflation poses a serious risk. Inflation that stays below 2% can lead to an unwelcome drop in longer-term inflation expectations. In turn, these expectations can drag actual inflation even lower, creating a vicious cycle of ever-lower inflation and expectations of inflation. This dynamic is an issue because inflation expectations feed directly into the overall level of interest rates.
Well-founded inflation expectations are crucial for providing the Federal Reserve the ability to support job growth without destabilizing inflation. If inflation expectations drop below the 2% target, then interest rates would decrease in tandem. As a result, the Fed would have a limited ability to cut interest rates in order to boost employment during a recession, further reducing its capacity to support the economy through interest rate cuts.
Revised Consensus Statement
To address the issue of persistently low inflation, the “Longer-Run Goals and Monetary Policy Strategy” was amended on August 27, 2020 with the unanimous support of FOMC participants. The revised consensus statement still seeks longer-run inflation of 2%; however, the timeline has changed. Instead of trying to achieve 2% inflation every year, the Fed now aims to achieve an average of 2% inflation over the long-term.
Therefore, after periods when inflation runs below its objective, the Fed will aim to keep inflation moderately above 2%, until inflation averages out at its target rate. To achieve this, the Fed is not “tying [itself] to a particular mathematical formula that defines the average.” Thus, the Fed’s approach could be seen as a “flexible form of average inflation targeting.” After years of falling short of 2% inflation, it would take 10 years of 2.5% inflation to offset target shortfalls since 2012.
With regards to the employment portion of the Fed’s mandate, the FOMC maintains its belief that the maximum sustainable level of employment can’t be measured. However, the revised statement’s language has been changed to reflect the central bank’s new view that a strong job market can be maintained without causing an outbreak of inflation. In practice, this means that the Fed will allow employment to run at or above real-time estimates of its highest level, unless signs of unwanted inflation growth or other risks crop up.
Implications for Commercial Real Estate
Historically, higher inflation has been a double-edged sword for CRE. While it increases the risk of larger debt costs, it also has bolstered equity flows into commercial real estate as a hedge on inflation. Despite the decreased risk of premature rate hikes, investors need to be cautious about the reaction of the bond market when economic activity lifts. The Fed’s elevated tolerance for inflation will continue to support the case for “lower for longer” interest rates, placing downward pressure on future cap rate movement.
As of late August, U.S. capital markets indicate that the estimated inflation rate for 2030 is only 1.75%, reflecting little concern about a surge in inflation and sparse faith in the central bank’s ability to shift the one economic variable it is thought to control. A possible solution lies in working in tandem with the federal government.
Rising inflation hinges on growth in the money supply and the velocity of money. While the central bank can raise the money supply, it can not spend the money it creates; that is Congress’s job. The federal government could increase spending on public goods, such as infrastructure, and broaden the safety net that limits the cost of economic bets gone bad for individual Americans.
Before the pandemic, such dalliances were quite rare, but a rising number of central banks are changing course. A partnership between the Federal Reserve and Congress may be the best way to try and halt coronavirus-related unemployment from turning into downright deflation.