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New FED policy with regard to inflation and interest rates

The Federal Reserve [FED], announced a major policy shift, saying that it is willing to allow inflation to run hotter than normal to enable support to the labour market and broader economy.

As a result of chairman of FED Jerome Powell calling the FED policy a “robust updating” the central bank formally agreed to a policy of “average inflation targeting.” Inflation refers to a rise in the prices of most good and services of common use. That means the central bank will allow inflation to run “moderately” above the FED’s 2% goal “for some time” following periods when it has run below that objective.

Practically, the move indicates that the FED will be less inclined to hike interest rates when the unemployment rate falls, so long as inflation does not creep up as well. Central bank officials believe that low unemployment leads to dangerously higher levels of inflation. The Policymaking Federal Open Market Committee approved the changes unanimously.

Powell said, “many find it counterintuitive that the FED would want to push up inflation. However, inflation that is persistently too low can pose serious risks to the economy.”

Dallas FED Robert Kaplan told that he would like to see inflation run higher with a range around 2.25%-2.5%.

The Federal Reserve Banks pay interests on required reserve balances and on excess reserve balances. The Board will evaluate the appropriate settings of the interest rates on reserve balances in light of evolving market conditions and will make adjustments as needed.

While the longer-term effects of covid-19 pandemic on US inflation are highly uncertain, the prospect of a sharp increase in prices during the latter end of expected recovery should not be ruled out. The longer the health crisis continues, the more three inflationary undercurrents could build in momentum: a longer-term supply-side shock, significant monetary expansion and the potential for a release of pent-up demand.

Since the end of financial crisis, the FED has struggled to hit 2% inflation target. Officials hope that the new approach will change the landscape, raising expectations and allowing inflation to float higher as rates remain low.

Reporter: Shriya Dwarakanath

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