One notable development over the past decade has been the Federal Reserve's increasingly dovish slant. During the Great Recession and ensuing years, several Fed appointees were on the hawkish side and warning that its actions would lead to inflation and financial instability.
Although economic growth was not optimal and the recovery was uneven, it's clear that these particular issues didn't occur. Now, the mantle has been seized by those who claim that it's evidence that the Fed wasn't aggressive enough - it should have waited for inflation to appear before it tightened.
In one sense, it's a generation shift, policymakers who lived through the high inflation of the 70s and 80s were biased to avoid that outcome. While younger policymakers who've lived through an era of low inflation but lackluster wage growth have a different mindset. Additionally, policymakers who were warning about inflation and financial stability either had to adjust their views and models or have been discredited.
Future Steps
Financial markets have been quite strong since the March bottom, and the economy has done better than expectations and continues to improve on a month to month basis. There remain some glaring issues like the high unemployment rate and lack of recovery in many parts of the economy. Additionally, there is the tradeoff between more economic activity in the short-term which risks the virus' spread increasing or less economic activity in the short-term which would help get the virus under control.
Another factor is the CARES Act and enhanced unemployment insurance which has resulted in a situation in which household incomes are higher now than before the coronavirus and has been supportive of spending. It's set to expire at the end of July and failure to extend it would lead to potentially disastrous outcomes.
Given these factors, it's likely that the Fed is going to add more stimulus in the months ahead. The two most likely methods are through "forward guidance" and yield curve control". Yield curve control means the Fed will buy an unlimited amount of bonds to cap the yield at a certain target on long-term debt. This will force investors to take more risk with their money and decrease the cost of money. It'll also be a big negative for banks since it will make lending less profitable.
Adjusting forward guidance means that the Fed can get desired outcomes through announcing its intentions or a change in thinking. Recently, we saw this with FOMC Chair Powell saying that interest rates won't be hiked until 2022. Another variant was in March when the Fed said it would be buying corporate bonds. This led to a rally in corporate bonds, and they hit their previous highs by the time the Fed started buying them in May. Just the announcement led to a big drop in corporate borrowing costs and removed one source of uncertainty for financial markets.
Another use of forward guidance could be the Fed announcing that it will abandon the Phillips Curve. The Fed has consistently forecast higher inflation than has materialized due to the Phillips Curve which says that increasing inflation follows low unemployment. This has been historically true and makes sense that low unemployment would lead to higher wages which leads to higher inflation. For whatever reason, this relationship has broken.
The Fed announcing that it's going to stop tightening policy when it anticipates inflation rising rather than actually waiting for inflation to rise would be a dovish step. For example, if this was in place over the last decade, it probably never would have stopped QE or raised rates from 2017 to 2019.