New Fed framework; and why it means a lot for India

Powell feels that the post-2008 era brings new challenges to monetary policy. Hence the traditional inflation targeting may not work.

August 28, 2020 1:37 IST | India Infoline News Service
The US Federal Reserve’s Monetary Policy Framework (MPF) has been a brainchild of Jerome Powell and had been in the works for nearly 2 years. The MPF was all about longer-term goals of monetary policy in the US. Typically, monetary policy moves from one policy to another. This leads to policy shifts at short notice creating turbulence and uncertainty in global financial markets. The MPF lays out the long term goals and articulate the framework of monetary policy for 5 years. Traders can now be reasonablysureabout trajectory of the Fed over next 5 years.

Why did this new MPF evolve?

According to Jerome Powell, there was the need for rethinking at the Fed. The Volcker-Greenspan era was largely about disinflation. However, Powell feels and his team have been of the view that the link between inflation and interest rates may be losing importance and the challenge ahead would be to leverage interest rates to fuel growth.The right mix of monetary policy and fiscal policy is also called for.

How the Fed Rates moved over last 25 years
Data Source: Trading Economics

In policy terms, it means interest rates in the US economy will not be pegged only to inflation, as in the past. Therefore, the Fed will be justified in future to keep interest rates at near zero levels even if inflation was above 2%. As Powell put it, there was the need to adapt policy framework to meet new challenges.Forty years back, the biggest problem for the US economy was high inflation which called for a focus on price stability. That triggered "Volcker disinflation," which was continued by Alan Greenspan.

Powell feels that the post-2008 era brings new challenges to monetary policy. Hence the traditional inflation targeting may not work.

Key triggers for the review and the new MPF

According to Powell, four broad factors triggered the need to shift the long term approach of monetary policy.

a) Most assessments of the potential, or longer-run, GDP growth rate of the economy have fallen. For instance, since January 2012, the median estimate of potential growth fell from 2.5% to 1.8%. This was due to ageing population and also loss of productivity.

Real Time real GDP forecast for the US economy
Data Source: US Federal Reserve

b) The global interest rates had fallen sharply post-2008. The median estimate from of neutral federal funds rate almost halved post-2012 from 4.25% to 2.50%. Hence, Fedhad limited scope to support the economy by merelycutting rates.

c) Thirdly, the economic expansion led to unemployment at record lows for 2 years in succession. It is estimated that the global financial crisis of 2019-20 might cause structural damage to the labour marketmaking it a bad benchmark.

d) Routine forecasts of return to 2% inflation never materialized as oil prices have remained low for over 6 years and strong labour market is hardly contributing much to inflation. This is true of most developed economies.

What is the new statement all about?

The Fed will give up the practice of specifying numerical goals for employmentas changes are unrelated to monetary policy. However, Fed will continue to maintain long-run inflation rate of 2%. But the biggest shift is that Fed Policy is likely to increasingly become forward looking than retrospective.

Additionally, Fed will be driven by average inflation rather than single point inflation. This will ensure that rough edges of growth and inflation are smoothened out. Going ahead, Fed may not be in a hurry to hike rates even if inflation goes above 2%. With oil prices weak and limited price visibility, rates may remain near zero for next 3-5 years.

What this new policy framework means for India?

The Fed NPF has 6 key implications for the Indian economy.

• If Fed is expected to keep rates around zero for next 3-5 years it gives room for the RBI to play with lower repo rates. With improved transmission, impact could be quicker.

• With low Fed rates, bond yields in the US will remain below 0.70%. That removes the worry that RBI rate cuts could lead to debt outflows by foreign investors.

• For the RBI, it is a signal that central banksare likely to focus monetary policy logic on growth rather than inflation in the coming years. That is good news for India.

• An important take-awayfrom the Fed MPF is that real action in terms of future growth triggers will come from fiscal front and not monetary front.

Figure 3 - How the Fed Balance Sheet Expanded

Data Source: Trading Economics

• The Fed balance sheet will continue to expand as shown in the chart above. That will keep emerging market liquidity buoyant, which is good despite price inflation.

• Lastly, India must use this opportunity to think of monetary policy on 2 structural lines. A focus on average rolling inflation instead of monthly CPI and a forward looking monetary policy will be useful shifts.

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