The Fed shifts on inflation – What does it mean?
The Fed unveiled a revision to its monetary policy, allowing for higher inflation to help support the labor market. We believe this action could keep interest rates low for years.
Last year, the Federal Reserve (Fed) announced a comprehensive review of its monetary policy framework. The purpose was to see if any changes could be made to help the Fed achieve its goals of maximum employment and price stability. Fed Chairman Jerome Powell recently announced the results of this framework review at the annual Economic Policy Symposium. The Fed is shifting to an average inflation target of 2% over the business cycle, compared to a strict inflation target of 2%. This might seem trivial, but the implications are significant.
An average inflation target allows the Fed to let inflation run above 2% for an extended period if inflation has been running below target. There is some question as to whether the Fed can get inflation to 2% given the deflationary impulses we have seen over the last decade. Nevertheless, this framework change could persuade the Fed to keep interest rates at zero for years to come. In other words, the Fed will likely wait longer than ever before raising interest rates.
Furthermore, we would expect the Fed to formalize its quantitative easing (QE) program by explicitly stating parameters around the pace and scope of bond purchases. Finally, the Fed will likely introduce new forward guidance around the timing of its first interest rate hike to reinforce its dovish stance.
One other important consideration is Powell’s commentary around employment. He indicated the Fed will be highly focused on achieving the strongest labor market possible. He also discussed the lack of inflation pressure in recent years when the unemployment rate fell to multi-decade lows, which gives the Fed confidence in pursuing a low unemployment rate.
Over the past year, several Fed officials have begun to discuss the unemployment rate for different racial and income groups, and Powell emphasized this point during his speech. Therefore, we think the Fed will allow the economy to grow at a stronger pace than usual to allow the unemployment rate to fall to very low levels for all people. This gives us further confidence that the Fed is likely to maintain an ultradovish monetary policy for several years, which could benefit both the economy and asset prices.
Past performance is not a guarantee of future results. This information is not meant as investment advice or to predict or project the future performance of any investment product. The opinions are current through August 2020, are subject to change at any time based on market and other current conditions, and no forecasts can be guaranteed. This information is being provided as a general source of information and is not intended as a recommendation to purchase, sell, or hold any specific security or to engage in any investment strategy. Investment decisions should always be made based on an investor’s specific objectives, financial needs, risk tolerance and time horizon.
Risk factors: Investing involves risk and the potential to lose principal. Fixed-income securities are subject to interest rate risk and, as such, the value of such securities may fall as interest rates rise. International investing involves additional risks, including currency fluctuations, political or economic conditions affecting the foreign country, and differences in accounting standards and foreign regulations. These risks are magnified in emerging markets.