The Fed adjusts its policies to meet the dual challenges of the new normal of inflation and interest rate constraints

In May 2025, global financial markets closely followed the progress of the Fed's monetary policy framework review. The current framework established five years ago is undergoing critical adjustments under the dual test of the impact of the epidemic and the shift in economic paradigms. This adjustment is not only about the reshaping of the Fed's strategy to deal with inflation and interest rate changes, but also reflects the deep dilemma of how global central banks can balance economic recovery and financial stability in the era of low interest rates.

Since the outbreak of the COVID-19 pandemic in 2020, the global economy has fallen into an unprecedented liquidity paradox: on the one hand, in order to hedge against supply chain disruptions and shrinking demand, major central banks have unprecedentedly implemented zero interest rates and quantitative easing policies; on the other hand, long-term low inflation and downward nominal interest rates have caused traditional monetary policy tools to fail. Federal Reserve data show that the federal funds rate actually touched the effective lower limit for 63% of the time between 2020 and 2024, far exceeding the historical average. This interest rate constraint forces the Fed to reassess the effectiveness of its policy tools.

A deeper challenge comes from structural changes in inflation expectations. The "fragile inflation" of the global supply chain and energy price shocks during the pandemic have significantly increased inflation volatility. The Fed's research pointed out that the standard deviation of core PCE inflation in 2022-2024 will expand by 47% compared with the 2010s. This volatility weakens the policy guidance significance of the traditional Phillips curve. In this context, the core goal of the Fed's framework adjustment is to build a new policy paradigm that can adapt to "high-frequency supply shocks + low interest rate constraints".

The new policy framework to be announced will achieve breakthrough reconstruction in three dimensions. First, the "effective lower limit forward guidance" is introduced in interest rate policy, which clearly recognizes the reality of the downward shift of the long-term interest rate center. The Fed has added the expression "long-term expected range of federal funds rate (2.0%-2.5%)", implying that future monetary policy will rely more on quantitative tools rather than interest rate adjustments.

Employment policy goals are given a higher weight. The new framework adjusts the measurement method of the maximum employment gap (MEG) from "unemployment rate deviation" to "labor market tightness index" and introduces an employment resilience assessment model. This change means that even if the unemployment rate falls below 4%, if the labor participation rate does not return to the pre-epidemic level, the Fed will still maintain an accommodative policy.

The most striking thing is the flexibility of the inflation target mechanism. The traditional 2% symmetric target has been upgraded to a "dynamic average inflation anchor", which allows for moderate overshooting when inflation continues to be below the target. Powell revealed in his May speech that the new framework will set up a "cumulative inflation gap compensation mechanism", that is, when the three-year average inflation is lower than 1.8%, subsequent policies will push inflation to a moderate rise of 2.2%-2.5%.

The impact of framework adjustment on policy practice is gradual. In the short term, the interest rate cut cycle that has been initiated at the FOMC meeting in December 2024 will continue, but the rhythm will be constrained by the new framework. The objection of Cleveland Fed President Hammack shows that there are still differences on the resilience of inflation, and it is expected that the interest rate cut in 2025 will be controlled in the range of 75-100BP.

The medium- and long-term impact is more structural. The new framework may reshape the mechanism for forming market interest rate expectations by strengthening forward-looking guidance. For example, under the expectation of economic recovery in 2026, when the 10-year US Treasury yield breaks through the threshold of 3.5%, the Federal Reserve may intervene implicitly through "yield curve control 2.0". In addition, the introduction of the employment resilience assessment model will prompt policy interest rate adjustments to refer more to job vacancy rates and wage growth rather than the traditional Phillips curve.

Risks and challenges still exist. The Republican-led fiscal expansion plan may trigger a new round of inflationary pressure, and the uncertainty of the global supply chain reconstruction process may make "fragile inflation" return at any time. In this context, the Federal Reserve needs to maintain a delicate balance between maintaining policy flexibility and defending inflation targets.

This policy framework reconstruction, which began with the epidemic, is essentially the Federal Reserve's re-cognition of economic laws in the post-globalization era. When traditional monetary policy tools encounter the dual constraints of the interest rate floor and inflation volatility, the construction of a flexible framework is both a compromise with reality and a strategic choice to reserve policy space for the future. This adjustment will not only reshape the volatility pattern of the US economic cycle, but may also become a paradigm sample for global central banks to cope with the challenges of the low interest rate era.