As expected, Federal Reserve Chair Jerome Powell announced a shift in policy that stems from a year-long review that the Fed has done. In a speech entitled “Navigating the Decade Ahead,” the key shift in policy is a move to an “average inflation” target instead of a precise 2% target. The change suggests that the Fed will likely maintain its zero-interest-rate policy for several more years until it sees inflation rise, rather than acting pre-emptively to address inflation expectations.
Bygones are no longer bygones
The Fed’s shift in policy implies that it will allow inflation to run at a pace above 2% for a period of time to offset the undershooting of inflation over the past decade. It is often referred to as letting inflation run “hot” for a while—although it’s hard to argue that 2.5% to 3.0% inflation is “hot.” In the past, the Fed viewed each inflation reading discretely. The past was gone, and all that mattered was the present and prospects for inflation based largely on the unemployment rate.
Inflation has fallen short of 2% for most of the past decade
Source: Bloomberg. Personal Consumption Expenditures: All Items Less Food & Energy (Core PCE) (PCE CYOY Index), percent change, year over year. Monthly data as of 6/30/2020.
The reasoning behind the Fed’s change in policy is the evidence that the relationship between the unemployment rate and inflation has changed. Lower levels of unemployment have not led to higher inflation during the past 10 to 15 years, as they had in previous years. In addition, the Fed has determined that demographic changes, such as the aging of the population along with slowing productivity growth, have led to a decline in the economy’s potential growth rate. The Fed’s estimate of potential gross domestic product growth has dropped to 1.8% from 2.5% in 2012. In turn, that suggests that the level of short-term interest rates associated with stable inflation is lower than in the past. The “neutral” federal funds rate is estimated at 2.5%, compared with 4.2% in 2012.
In announcing the Fed’s change in policy, Powell indicated that the fed funds rate would stay near zero until inflation rises above 2% “for some time.” The Fed has allowed itself a lot of flexibility, however. There is a heavy emphasis on achieving full employment, which now appears to be the Fed’s primary goal, considering that inflation remains quite low and unemployment very high.
High unemployment is one of the Fed’s biggest concerns
Source: Bureau of Labor Statistics. Civilian Unemployment Rate and Underemployment Rate, Total unemployed, plus all marginally attached workers plus total employed part time for economic reasons (U6 Rate), Percent, Monthly, Seasonally Adjusted. Shaded area indicates recession. Monthly data as of July 2020.
Powell provided no indication of how the Fed hopes to achieve higher inflation. That’s probably because the Fed has already expanded monetary policy dramatically, without lifting inflation. It can continue to keep short-term interest rates near zero, expand its balance sheet by buying more bonds to hold down long-term interest rates, and use its special facilities to lend. However, these tools are stretched already. Many Fed officials have been urging Congress to pass more fiscal relief, as that would likely have a more immediate effect in boosting growth, employment, and inflation.
Evolution, not revolution
Powell’s speech is important in that it codifies the Fed’s approach to policy. However, it isn’t a big change from the way the Fed has been operating for a while now. It will help set expectations about policy by identifying the key factors that are important to the Fed. However, monetary policy can only do so much. The biggest risk to the policy shift is that long-term rates could rise on the assumption that the Fed would not respond to inflation fast enough to contain it.
Inflation expectations have already been rising, but remain below 2%. The Fed could find itself needing to react more quickly than it would like to quell those expectations. Yield curve control could be employed at that stage—with the Fed buying longer-term bonds to hold down yields. That doesn’t appear to be a near-term issue, but it could be a longer-term issue.
Market expectations for inflation have been rising but remain below 2%
Source: Bloomberg. U.S. Breakeven 10 Year (USGGBE10 Index) and U.S. Breakeven 5 Year (USGGBE05 Index). Daily data as of 8/27/2020.
Bottom line: The Fed’s policy announcement has reinforced our view. We look for the Fed to keep short-term interest rates low for several more years, and the U.S. dollar to weaken further over time.