The conflict between Israel and Iran, which has captivated global attention, has finally come to an end. This has allowed people to refocus on the Federal Reserve’s monetary policy. Just at this moment, Federal Reserve Chairman Jerome Powell testified before the House and Senate on June 24 and 25, addressing key issues such as the economic situation, the impact of tariffs, inflation prospects, the next steps in monetary policy, the U.S. dollar’s status, tax cuts, and immigration policy. Regarding monetary policy, Alaric paid particular attention to Powell’s discussion of the latest progress on the Fed’s monetary policy framework review, as it is a key factor influencing the direction of monetary policy for the next five years, or even longer.
Why is this important?
Since 2012, the Federal Reserve has annually approved and published a “Statement on Long-Term Goals and Monetary Policy Strategy” to explain its understanding of the dual mandate of price stability and full employment, as well as the strategies and methods to achieve those goals. Over the years, this statement has undergone slight textual adjustments, but its essence has remained largely unchanged. It is based on the “Phillips Curve,” which posits a negative correlation between unemployment and inflation. When unemployment falls to a certain level, prices begin to rise, and the central bank should then adopt a proactive strategy, tightening monetary policy before inflation increases. Alaric refers to this as the “traditional framework” of U.S. monetary policy.
Under this framework, the Federal Reserve has faced significant challenges for a long time: first, the Phillips Curve, which showed a trade-off between unemployment and inflation, has failed, with inflation consistently remaining below the 2% target; second, typically, an increase in fiscal deficits leads to rising interest rates, but now with a massive increase in debt, interest rates have not risen but instead have fallen; third, in the low-interest, low-inflation environment, the space for conventional monetary policy tools has reached its limit.
If these challenges persist, monetary policy would be in a difficult position. Therefore, in 2019, the Federal Reserve decided to reevaluate this policy framework and to conduct such a review every five years. The review of the framework was completed in August 2020, which Alaric calls the “new framework.” The new framework emphasizes maximizing employment, stating that even if full employment is reached or exceeded, there is no immediate need to tighten monetary policy; the long-term inflation target remains at 2%, but it also emphasizes that when inflation has been below 2% for a period, the next stage allows inflation to rise above 2% for a while. This is a “flexible form of average inflation targeting,” as opposed to the earlier “symmetric 2% long-term inflation target.” The aim of this adjustment is to allow inflation to overshoot, pushing inflation expectations higher, and making monetary policy more expansionary.
In practice, however, the timing of this transition from the old to the new framework was less than ideal. Some argue that the framework change led the Federal Reserve to focus too much on employment targets, which delayed interest rate hikes to counteract the post-pandemic surge in inflation. The personal consumption expenditures (PCE) price index surpassed the 2% target in March 2021, breached 5% in October of that year, and peaked at 7.1% in June 2022. Yet, the Federal Reserve did not begin raising rates until early 2022. Some argue that it was the new framework of 2020 that limited the Fed’s response to inflation. While Powell does not agree with this view, many hold it.
At the end of 2024, the Federal Reserve announced the initiation of another review of its framework. The Federal Open Market Committee (FOMC) meeting in January 2025 emphasized that the new framework must be “robust under all circumstances,” since the current policy framework was designed during a period of sustained low interest rates and low inflation, making it too narrowly tailored to specific economic conditions. In mid-May, Powell stated that since 2020, the economic environment has changed significantly, and the current framework evaluation would reflect an assessment of these changes. The Fed is entering a period with more frequent and potentially more persistent supply shocks, posing a significant challenge. Key elements of the monetary policy framework will need to be revised, including how employment shortages and inflation targets are viewed. In late June, during hearings in the House and Senate, Powell provided an update on the framework evaluation, stating that discussions on price stability and full employment had been mostly completed, and that the wording in the documents was currently being deliberated.
In Alaric’s view, during this evaluation, it is expected that the Federal Reserve will continue with the 2% inflation target, though the “flexibility” of the target may be adjusted, and there is a possibility that it may return to the “symmetric” 2% inflation target. The phrasing around full employment may become more relaxed compared to previous formulations. Based on this, the Federal Reserve may partially restore previous practices, such as tightening interest rates proactively when the labor market is strong to prevent inflation expectations from rising too quickly. Finally, when inflation and employment targets conflict, will the Fed maintain high interest rates to combat inflation, or lower rates to support employment? This will be a dilemma the Federal Reserve faces during the five-year monetary policy framework review.