FOMC has an asymmetrical loss function - BNPP

The FOMC has an asymmetrical loss function as avoiding a recession is more important than avoiding the risk of overheating, according to William De Vijlder, Research Analyst at BNP Paribas.

Key Quotes

“The Federal Reserve faces two asymmetries. The first is the asymmetric loss function. This is largely by choice because it wants to avoid triggering a recession (fighting recessions has become increasingly difficult). Chairman Powell insisted in his press conference on Wednesday on the need not to tighten too quickly. Otherwise inflation would rise insufficiently which would make it more difficult to tackle the next recession when it comes. The second asymmetry is imposed on the central bank. At the same time, we note that since 2000, 75% of observations of core inflation were below 2%. Engineering an uplift in inflation towards the 2% target looks like a huge task.”

“Faced with these two asymmetries, insisting that the inflation objective is symmetrical, like Jerome Powell re-iterated on Wednesday, becomes an obvious, not to say inevitable, conclusion: allowing a temporary inflation overshoot is the price to pay for the wish to avoid the most uncomfortable part of the loss function (a recession) that could ensue from what would turn out to be a prematurely restrictive policy stance. This is all the more rational given the difficulty of assessing the level of the natural rate of unemployment and the uncertainty about the relationship between the unemployment rate and inflation. Taking the risk that the Phillips curve re-emerges then makes sense.”