Sept 1, 2020
At the beginning of 2019, the US Federal Reserve (Fed) began a year-long review of its strategy, tools and communication. The context was the long-drawn-out period of low equilibrium interest rates in the global economy, ‘r-star’ in economic jargon. With such low equilibrium rates (interest rates that are consistent with stable inflation), it became far more likely that in an economic downturn the central bank’s official policy rates would hit their Economic Lower Bound – making further rate cuts to boost economic activity impossible.
Additionally, the relationship between wages and inflation had become seemingly dormant, reflected in a relatively flat Phillips curve, which plots wages against the unemployment rate and hence inflation. The breakdown of this established economic relationship manifested itself in a strong labour market but with inflation outcomes that consistently undershot the Fed’s 2% target. This reflected the fact that both society’s expectation of inflation and realised inflation outcomes had become ‘unanchored’ from the Fed’s inflation target – a side-effect of the Fed’s policy of pre-emptively hiking rates as employment rates went up, rather than waiting for the lower unemployment rate to feed through into price rises. The Fed needed to address this issue to ensure an important monetary policy tool (interest-rate policy) remained effective.
Put simply, the Fed’s review was trying to ensure that its operating regime was fit for purpose. To do that, the Fed asked itself three broad questions:
After widespread consultation with its stakeholders, the Fed initially planned to unveil the results of the review early in 2020. But, of course, the COVID-19 pandemic interrupted this agenda and, in an aggressive response, policymakers found themselves back at the Economic Lower Bound of interest rates far earlier than they had planned or expected.
On 27 August, the Fed’s Chair Jerome Powell communicated the result of the review to the world, having embedded these changes within an updated and revised “Statement on Longer-Run Goals and Monetary Policy Strategy”, the document that sets out, as the title suggests the Fed’s monetary policy mission statement. Two changes to the previous Statement were introduced. Firstly, and in the chair’s words:
“Our revised statement emphasizes that maximum employment is a broad-based and inclusive goal. This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities. In addition, our revised statement says that our policy decision will be informed by our “assessments of the shortfalls of employment from its maximum level” rather than by “deviations from its maximum level” as in our previous statement. This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation. The change to “shortfalls” clarifies that, going forward, employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation or the emergence of other risks that could impede the attainment of our goals.”
This suggests the Fed is moving away from an empirical assessment of full employment to something more discretionary and, in particular, a focus on those marginally attached to the labour market. The second change was to inflation where, and again in the chair’s words:
“Our new statement indicates that we will seek to achieve inflation that averages 2 percent over time. Therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time. In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average…Our decisions about appropriate monetary policy will continue to reflect a broad array of considerations and will not be dictated by any formula.”
This fairly vague inflation averaging will seek to achieve a more ‘symmetrical’ outcome for inflation relative to that seen in the past ten years, when inflation has consistently undershot – rather than overshot – targets.
We have the theory, but Powell left the ‘how’ unsaid, largely as the Fed sees its objectives and appropriate policy to achieve those objectives as quite different.
It’s a little like a portfolio’s objective and the process needed to meet that objective. The latter is formulated at FOMC meetings and so attention turns to the next FOMC meeting on 16 September. However, with interest rates already at zero and quantitative easing in full flow, the tools the Committee has left are limited.
Most likely, members will adopt ‘state based forward guidance’ by promising to keep interest rates at their current level until they believe the US economy has achieved its new definition of broad-based full employment, and inflation has actually risen to a level modestly above the Fed’s unchanged inflation target of 2%. If necessary, the Fed will reinforce this guidance with empirical yield-curve targets and – most definitely – continued quantitative easing. Of course, this would have been far easier to achieve in a pre-COVID world and it will take five to ten more years hence to pass judgement on the Fed’s shift, as it is only once a recovery is in full swing and capacity constraints are pushing inflation higher that we will be able to assess if it managed to achieve its goals.
The implications of the Fed’s moves are enormous. In effect, the central bank of the world’s largest economy has become more dovish: the Fed will not raise interest rates if inflation is forecast to breach its target, instead it will wait until inflation is modestly above target before hiking rates. The aim is to ensure monetary policy does not choke off the economy and de-anchor inflation expectations. In terms of markets, this implies higher realised inflation and therefore lower real yields, as nominal yields remain unchanged but inflation rises. If other major economies are unable to achieve lower real interest rates, their currencies may outperform, pushing the US dollar lower. Gold should be well supported in such an environment. A long period of zero official interest rates will see investors’ search for yield continue for years – a potential positive for high-yield debt and emerging market assets. And since equity investors can discount future company earnings using medium-term interest rates that are pinned to the floor for several years, we think the move is a positive for equity markets too.