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After its meeting on August 27, 2020, the Federal Open Market Committee (FOMC) announced a new approach to controlling inflation through the benchmark federal funds rate. While affirming that it considers a 2% inflation rate optimal for promoting maximum employment, stable prices, and moderate long-term interest rates, the Committee indicated that it had more concern about persistently low inflation than high inflation and would seek to achieve inflation that averages 2% over the long term.1
In the past, the FOMC has increased the funds rate proactively to keep inflation from rising above 2%. According to the new strategy, when inflation has been running persistently below 2%, as it has for the past decade, "appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time."2
What This Means for You
Although this may seem like a subtle change, it could have a significant effect on personal finances, investing, and the broader economy. To stimulate the economy in the face of the COVID-19 recession, the FOMC dropped the federal funds rate in March 2020 to its rock-bottom level of 0% to 0.25%, as it was during the Great Recession and the early years of recovery. At that time, there was concern that an extended period of low rates might cause high inflation, and the Committee began to increase the federal funds rate proactively in December 2015 and became more aggressive with increases over the next three years (see chart).
Controlling Inflation
The FOMC's preferred inflation measure is the Personal Consumption Expenditures (PCE) Price Index, which tracks expenditures on a broader range of goods and services than the Consumer Price Index and reflects changes in consumer behavior. For its 2% target, the Committee focuses on "core PCE," which strips out volatile food and energy categories that are less likely to respond to monetary policy. From 2015 to 2019, the FOMC raised the federal funds rate to keep inflation under its 2% target, but it will not be so quick to act under the new policy.
Sources: Federal Reserve and U.S. Bureau of Economic Analysis, 2020 (data for the period 9/2010 to 9/2020)
Under the new policy, the FOMC is likely to be slower to raise the funds rate even if inflation begins to edge up over 2%. At its September 16, 2020, meeting, the Committee projected that the federal funds rate would remain near zero through 2023.3
This strategy will keep most other interest rates low. The federal funds rate directly affects short-term interest rates, including the prime rate that commercial banks charge to their best customers. The prime rate, in turn, serves as a benchmark for many types of consumer loans such as auto loans and credit cards. Mortgage rates have a more indirect connection to the federal funds rate and the prime rate, but they are likely to stay relatively low in a broad low-interest environment.
Low borrowing costs are generally good for businesses and consumers, which is why the FOMC drops rates to stimulate the economy. But low rates also mean lower yields on fixed-income investments, which may force investors looking for higher yields to take on more risk than is appropriate for their situations. This could be especially problematic for retirees who depend in part on interest income. And while moderately higher inflation may not be a big strain for workers as long as income keeps pace with prices, higher inflation can cut into the purchasing power of retirement savings.
It's unlikely that the FOMC will let inflation get out of control, but it's also unlikely that interest rates will rise significantly in the absence of strong inflationary pressure. You may want to revisit your debt management and retirement income strategies in light of the expectation for a prolonged period of low interest rates.
The principal value of fixed-income investments may fluctuate with market conditions; if redeemed prior to maturity, they may be worth more or less than their original cost.
1–3) Federal Reserve, 2020
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