The Fed’s new policy framework is about to be tested 

Next week’s Federal Open Market Committee meeting promises to be one of the most interesting in recent memory. Based on comments of Fed officials, the vote about whether to lower the fed funds rate by a quarter point for the third time in the last three meetings could be very close. 

This is reflected in the heightened U.S. stock market volatility since the Federal Open Market Committee’s last meeting in late October.  

The stock market sold off after Fed chair Jerome Powell cautioned that there were “strongly differing views about how to proceed in December” and a further reduction in the benchmark rate was not “a foregone conclusion.”  

More recently, the stock market rallied following press reports that allies of Powell have laid the groundwork for him to push through a rate cut at the upcoming meeting even though it could draw multiple dissents. 

Nick Timiraos of the Wall Street Journal reports that the option that seems to be gaining traction is to cut rates in December but then signal there is a higher bar to further rate reductions. He observes that doing so could end “the soap opera” of officials airing their disagreements in public. 

Treasury Secretary Scott Bessent views this as a welcome development. In a CNBC interview he said: “I think it’s time for the Fed to move to the background like it used to do, calm things down, and work for the American people, set monetary policy on a good path.” 

The challenge Fed officials face is that the stated goals of pursuing full employment and price stability are now at odds. The job market is softening and unemployment is edging up, while core inflation is nearly a full percentage point above the Fed’s 2 percent target, and it could stay elevated next year.   

When the twin goals are in conflict the Fed at times has given greater weight to tackling unemployment than curbing inflation, with Paul Volcker’s tenure as Fed chair the prime exception.

The reason is that rising unemployment has been perceived to take a greater toll on peoples’ lives than a temporary rise in inflation. 

This perspective was formally adopted by the Fed in August 2020, when it unveiled a new policy framework called Flexible Average Inflation Targeting.

The backdrop was that U.S. inflation had been below the Fed’s target for several years, and officials believed it should aim to achieve inflation moderately above 2 percent while pursuing the goal of “maximum employment.” 

The adoption of Flexible Average Inflation Targeting meant that there was an asymmetric bias in favor of supporting maximum employment over fighting inflation. 

One year after its adoption, however, inflation began to spike. It eventually reached its highest level since the early 1980s owing to supply chain disruptions associated with the COVID-19 pandemic and stimulative fiscal and monetary policies that boosted aggregate demand. 

In the process, many lower and middle-income families bore the brunt of higher inflation, and they complained about their living standards becoming unaffordable.

A U.S. Census Bureau survey in April of this year found that when inflation peaked, 64 percent of low-income respondents found it “very stressful” versus only 17 percent of the richest group.   

In response to growing criticism, Powell officially announced the end of Flexible Average Inflation Targeting at the 2025 Jackson Hole Economic Summit. The Fed has now reverted to a more traditional framework that emphasizes a balanced approach when its employment and inflation goals are in conflict. 

The December Federal Open Market Committee meeting has taken on added significance in the wake of this development, because it provides the first opportunity to observe how the Fed will interpret its new framework.  

Specifically, is the Fed willing to accept that inflation may stay above its target into 2026? If so, will it take into account the burden that inflation imposes on many lower and middle-income families? 

An argument that is commonly made for lowering interest rates is it will make housing costs more affordable.

The counterargument, however, is that fixed rate mortgages are tied to long-term bond yields rather than short-term rates. One risk in lowering the funds rate too quickly is that bond yields could increase if investors perceive the Fed is not resolute about curbing inflation. 

Thus far, investors have not questioned the Fed’s commitment to keep inflation under control. However, perceptions could change depending on whom President Trump nominates to be the next Fed chair. 

Kevin Hassett, director of the National Economic Council, is regarded as Trump’s choice. Some observers believe his appointment might increase the possibility that the Fed’s independence could be compromised, especially if the Supreme Court upholds Trump’s decision to fire Fed governor Lisa Cook. 

Although it is too early to tell how changes in the Federal Reserve’s governance will play out, one thing seems clear: Namely, the days in which votes of Federal Open Market Committee members are unanimous appear to be over. 

Nicholas Sargen, Ph.D. is an economic consultant and is affiliated with the University of Virginia’s Darden School of Business.