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.
COVID-19 update. New COVID-19 cases continue to trend lower in the U.S. and related hospitalizations are falling as well. Unfortunately, new cases are moving higher in other parts of the world. This is especially true in Europe, with infection rates in France nearing their previous peak. The good news from an economic point of view is that European governments have indicated they will institute targeted restrictions in response to the new virus trends and will seek to avoid the broad lockdowns that were so punitive to growth back in the spring. While European economic data has broadly continued to improve to this point, we do expect a slowdown in growth to emerge due to the resurgence in cases.
Globally, growth has been mixed, but generally on the positive side. In the U.S., we have been surprised by the strength in recent economic data, with the consumer proving to be very resilient, despite emergency unemployment benefits expiring at the end of July. The expiration of those benefits means about $14 billion per week less in unemployment payouts, which is about a 4% hit to income. However, our real-time indicators show that not only has spending held up, it has increased in the last few weeks. While we do not have a definite answer to what is behind the buoyant spending, we do think that back-to-school shopping could be a possible driver. In addition, savings rates near record levels mean that many consumers had a pool of funds they could continue to draw on after government payments fell.
Finally, as COVID-19 case numbers continue to fall, those consumers with jobs could be feeling more confident about shopping and dining out. Ultimately, we believe that if we do not get an extension of benefits from the Trump administration and Congress, we will eventually see a slowdown in consumer spending.
The Fed. The biggest news of the past few weeks came from Federal Reserve (Fed) Chairman Jerome Powell’s speech last week to the Fed’s Jackson Hole conference. We believe his speech is very important for markets, as Powell outlined a dramatic change in the way the Fed will pursue its dual mandate of maximum employment and price stability. On the price stability or inflation side, Powell announced that the Fed will be moving to average inflation targeting. Having fallen short of their 2% inflation target over the past few years, the Fed now will allow inflation to overshoot moderately the target rate to maintain its 2% average target. While this might not sound like a substantial change, we believe it will be very impactful to markets.
Powell also addressed the employment side of the Fed’s mandate. In the past, the Fed looked at the unemployment rate and compared it to the “natural rate” of unemployment (the rate at beyond which wages start to accelerate and stimulate inflation.) Historically, when the unemployment rate dipped toward the natural rate, the U.S. central bank would start raising rates to head off inflationary pressures. In the most recent cycle, the Fed viewed the natural rate of unemployment as being around 5% and began raising interested rates when the unemployment rate fell to that marker. In hindsight, that was a policy mistake because inflation never materialized, and they continued to miss the inflation target.
Powell is now saying that the Fed is going to push for a very low unemployment rate because there is no evidence inflation results from tight labor markets. Further, he gave voice to concerns about disparities in wealth, income and employment among different demographic groups. This is a theme we have heard repeatedly mentioned by other Fed officials in recent speeches. Powell specifically talked about the lower unemployment rates across all racial and income groups. Even if the unemployment rate is low, if you have disparities among these groups there is still a problem and the Fed will try to push the unemployment rate down far enough to benefit all people. From a practical perspective, we believe this means the Fed will remain ultra-dovish for a long-time to come and this will be very supportive for risk assets and the economy.
U.S. elections. After the party conventions of the past two weeks national polls show former Vice President Joe Biden leading President Donald Trump by an average seven points. Trump did see a rise in his polling numbers in early August, but those have stalled out over the last couple of weeks. However, Trump is gaining ground in key swing states that he won in 2016. While Biden is obviously still the favorite, this is something to watch in the coming weeks. The betting odds for a Trump victory have increased to 46% from 40% earlier this month. Perhaps just as importantly, the odds for the Republicans retaining the U.S. Senate have seen a massive swing, going from 38% to 51% over the same time period. We believe the markets would view this favorably, as a Democratic sweep of the presidency and both houses of congress could likely increase market volatility over fears of potentially negative policies.
Market update. Equity markets continue to move higher. The value segment of the market has been doing better over the past week and we believe this was helped in part by the measures announced by Powell last week. The yields on U.S. Treasury bonds have been drifting higher and the Fed’s actions pushed them even higher still, which again benefits the value trade. The Fed’s shift also weighed on the U.S. dollar, which continues to weaken.
With the Fed’s actions, the market is starting to price in higher inflation expectations. However, we believe we are still in an environment where a broad and sustained move higher inflation is unlikely. In order to generate inflation, we believe we would need a combination of the Fed’s easy monetary policy coupled with continued aggressive fiscal stimulus and this after we get a vaccine and a return to some sense of a normal economy. Otherwise, we think it will be several years before we see an actual significant and sustained rise in inflation.
In Japan, Prime Minister Shinzo Abe resigned last week. Abe had an outsized influence on the Japanese economy during his tenure, as he reversed years of tight monetary and fiscal policy. He also instituted many reforms to spur economic growth. Abe is likely to be replaced by someone who maintains his policies for now; therefore, we do not expect changes over the next year.
Past performance is no 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 Aug. 31, 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.
The impact of COVID-19, and other infectious illness outbreaks that may arise in the future, could adversely affect the economies of many nations or the entire global economy, individual issuers and capital markets in ways that cannot necessarily be foreseen. In addition, the impact of infectious illnesses in emerging market countries may be greater due to generally less established healthcare systems. Public health crises caused by the COVID-19 outbreak may exacerbate other pre-existing political, social and economic risks in certain countries or globally. The duration of the COVID-19 outbreak and its effects cannot be determined with certainty.