Jonathan Marriott, Chief Investment Officer
After a year and a half review, Jay Powell, speaking at the Jackson Hole Symposium, announced changes to the Federal Reserve's (Fed) long-run goals and monetary strategy. Most significantly, they have changed the way they target inflation and full employment. These alterations should result in interest rates remaining low for even longer and may give the Fed more room to take action at the next meeting.
The Fed targets 2% inflation as per many other central banks; this has not changed. This implies that if inflation is above target, they should raise rates, subsequently tightening monetary conditions. If inflation is below target, they should ease monetary conditions to stimulate the economy. The recently announced revision means they will now look at an average inflation, so if the rate has been below 2% for a time, then it would be allowed to go higher for a time afterwards to compensate for the period of low inflation. Since their preferred measure of inflation has been below target for most of the last ten years, this would allow interest rates to remain low for some time, even after the 2% target had been breached. The Fed has been keen on transparency in recent times but are not defining the "average" they will use, in terms of time period or the scale of deviation that would be allowed. This gives them considerable room for manoeuvre.
The Fed continues to have a long-run target of full employment. However, the definition of full employment has been adjusted as falling unemployment failed to produce inflation. The previous statement referred to policy decisions being based on "deviations" from maximum employment; it is now going to be based on "assessment of the shortfalls of employment from its maximum level". This change of wording implies an asymmetric approach to the maximum employment target.
Inflation targeting came about against the background of damaging high rates of inflation in the 1970s and 80s. High inflation makes planning expenditure difficult, devalues savings and damages the economy. Deflation can be equally as damaging to the economy as people and businesses delay expenditure harming economic growth. The 2% target was sufficient to avoid the risk of deflation while avoiding the risk of high inflation. This target has been widely adopted by central banks across the world, but in recent times, meeting this target has been difficult as deflationary forces have weighed on the economy. Advances in technology, automation, globalisation and aging populations have all made it hard to raise prices. Since the financial crisis, central banks have been keeping rates low and using novel methods to add monetary stimulus without much impact on inflation. Prior to the COVID-19 pandemic, unemployment had fallen to record lows in the United States and yet inflation remained stubbornly low.
The review to the Fed's strategy was not in response to COVID-19 and it will be reviewed again in five years' time. With unemployment much higher as a result of measures to restrict the spread of the disease, and the huge economic stimulus introduced to support the economy, these moves may seem unimportant. However, they will have a bearing on monetary policy as we recover from the pandemic and could make it easier to add more stimulus now. This should be broadly supportive for equity markets. The inflation rate predicted by ten-year US Treasury Inflation Protected bonds (TIPs) is just 1.75%, so these may look attractive in comparison to conventional bonds. Low interest rates for longer may support short-term bonds. If interest rates remain low allowing inflation to run above target for a time, when the Fed eventually tightens monetary policy they may have to do so more aggressively in the long term, so we may finally see higher rates as they move to control this.
The Bank of England has an explicit aim to target 2% inflation, as does the European Central Bank (ECB) and Bank of Japan. They do not, however, have the Fed's same mandate for full employment. The ECB has struggled to stimulate inflation and economic growth since the 2008/09 financial crisis. Monetary policy alone is a blunt instrument when trying to create inflation. Japan has been trying to stimulate the economy and inflation, with zero interest rates and huge fiscal packages, for longer than anyone else, with little impact. As a consequence of the pandemic, we have seen near zero interest rates and massive fiscal stimulus to save the global economy. Some economists fear that the size of the stimulus will result in inflation, but with high unemployment restricting the consumer, and other aforementioned deflationary pressures may constrain this. Given the changes to the Fed's strategy, it will be interesting to see if the long-run goals of other central banks are similarly revised. In the short-term, we will be observing with interest the Fed meeting in September for further moves to support the US economy.
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