The Outlook: September 2020 Economic commentary
A Q&A on the US Federal Reserve’s new monetary policy framework
Jerome Powell, the chairman of the US Federal Reserve, recently announced a change to the US central bank’s monetary policy framework. Our Chief Economist, Colin Warren, answers questions regarding what this could mean for the economic and financial market outlook.
How has the Fed’s policy framework changed?
In effect, the Fed has changed the way it will react to developments regarding inflation and unemployment. Regarding the former, the Fed has adopted a flexible form of average inflation targeting; rather than viewing its 2% inflation target as a ceiling, the Fed will seek to achieve inflation that averages 2% over time. The approach is flexible because the Fed is not tying itself to any particular mathematical formula or time period over which the average will be calculated. In practical terms, following a period when inflation has been below 2% (as has been the case in recent years), the Fed will allow the economy to ‘run hot’ and inflation to rise moderately above 2% to compensate.
In addition, the Fed will no longer tighten monetary policy solely because unemployment is low. In the past, the Fed has pre-emptively raised interest rates when unemployment has fallen towards levels that it saw as likely to push up inflation in the future. The reasoning was that as the jobless rate fell, workers would bid up wages, and inflation would rise as companies passed on higher costs to consumers. However, recent experience has shown that, for various reasons such as globalisation and de-unionisation, the level of joblessness consistent with low inflation has fallen. The implication is that the Fed will now only consider tightening policy if wages and prices are actually picking up, and only then when it sees inflation as consistent with its 2% average target.
What does this mean for the monetary policy outlook?
Fed officials have flagged a shift in strategy for a while now, but the formalisation of the change has reinforced expectations that the Fed’s policy interest rate (which currently has a target range of 0.0-0.25%) will stay close to zero for a long time1. With inflation currently running at 1.3% and the unemployment rate more than double pre-pandemic levels2,3, the Fed has indicated that it is unlikely to raise interest rates before 20244. As the Fed is reluctant to take official interest rates into negative territory, the favoured tool to add further stimulus to the economy would be to increase the pace of its current quantitative easing (QE, or buying bonds) programme.
How far above 2% might the Fed let inflation rise before tightening policy?
This is not clear, as the Fed has not specified a formula or a time period over which the average will be calculated5. However, to give some idea, it is instructive to note that during the five years to July 2020, inflation as measured by the personal consumption expenditure deflator (the PCE deflator - the gauge used for the Fed’s inflation target) averaged 1.4%. This suggests that an average inflation rate of 2.6% over the next five years would be required to make up the shortfall6. This ballpark figure is in line with recent comments from St. Louis Fed President James Bullard, who has said that under the new strategy inflation could ‘… run above (2%) for half a percent for quite a while…”7.
However, the Fed is unlikely to bind itself to any concrete rules, and views amongst policymakers will differ. Moreover, the nature of any inflation overshoot is likely to have a bearing on policy decisions. An overshoot of inflation resulting from, say, a spike in oil prices due to geopolitical tensions is likely to be deemed less significant than a broad-based rise in service sector inflation due to accelerating wage growth. In short, the Fed will leave itself a lot of leeway.
Will the Fed actually be able to generate inflation above 2%?
According to the Fed’s own economic projections released following its 15-16th September meeting, inflation on the PCE deflator measure is not expected to rise to 2.0% until the end of 2023. This suggests the Fed is not expecting an inflation overshoot within its 3-year forecast horizon4.
A sharp increase in money supply growth during the pandemic has prompted some economists of a monetarist persuasion to warn that a faster pace of consumer price rises are in the offing8. However, in light of the current slack in the economy and the structural forces bearing down on prices, most observers are doubtful that inflation will rise above 2% anytime soon9. Official interest rates are already close to zero, thus limiting the degree to which the central bank can provide further stimulus. Moreover, QE has been effective in boosting asset prices in recent years, but has so far been less successful in meaningfully raising consumer price inflation.
Part of the problem is, as Chair Powell has noted, that the Fed has “lending powers, but not spending powers”10. With this in mind, a key factor determining the outlook for inflation will be fiscal policy i.e. government spending and taxation. Higher government expenditure funded by Fed purchases of bonds would be a potent policy combination that could stimulate demand sufficiently to lift inflation. The limited scope for monetary tools alone to further boost the economy explains Chair Powell’s repeated calls for increased fiscal stimulus in recent months11. A ‘Democratic sweep’ in November’s election that introduces an expansionary fiscal programme (see our commentary of August 2020) would significantly shift the Fed’s chances of success and is likely to result in inflation forecasts being revised up
The prospect of an extended period of accommodative monetary policy and negative real (i.e. after inflation) interest rates also carries the potential to put further downward pressure on the US dollar. In turn, this could lift inflation by boosting import prices and lifting demand for exports. Ultimately, the Fed could weaken the US dollar by using freshly-printed dollars to buy the bonds of foreign governments, although such a move would be controversial.
Expectations could also play a role in lifting actual inflation. If consumers believe that inflation is going to pick up, they might become more inclined to spend (i.e. buy now, rather than pay more later) rather than save. Higher inflation expectations could also encourage increased wage demands by workers. Whether such demands are actually granted is another matter, although a possible hike in the federal minimum wage and increased worker protections under a future Democrat administration (see our commentary of August 2020) would make significant pay hikes more likely12,13.
What could the change in the Fed’s framework mean for bond markets?
The Fed’s shift to average inflation targeting reinforces the view that US government bonds, and developed market government bonds more generally, will prove an unattractive investment over a multi-year timeframe. Inflation is bad news for bonds, as higher prices undermine the purchasing power of future cash flows. A sustained period of near-zero policy rates should serve to anchor yields, particularly those on bonds of shorter maturities. However, with the 10-year US Treasury yield currently hovering around 0.7%, an investor purchasing such a bond and holding it to maturity will almost certainly experience a negative real, or inflation-adjusted, return14.
Indeed, comparing this nominal yield with the equivalent -1.0% real yield on US treasury inflation-protected bonds shows that markets currently expect CPI-based inflation to average about 1.7% over the next 10 years15. This suggests markets don’t believe that the Fed will succeed in achieving average inflation of 2% on its preferred PCE deflator measure (PCE inflation tends to come in somewhat lower than CPI inflation due to technical factors)16,17.
At the current juncture, uncertainty over the coronavirus, policy gridlock in Washington and the forthcoming US election is weighing on government bond yields. However, further down the line, there is clear scope for the Fed’s inflation strategy, combined with progress regarding a vaccine, economic recovery and elevated levels of bond issuance to push up longer-term yields faster than those on shorter-dated bonds - a phenomenon known as a steepening of the yield curve.
What about equities?
As we have discussed previously (see our commentary of June 2020) the Fed’s monetary policy is a key driver of US, and global, equity markets. Historically, periods of monetary tightening from the US Fed have often culminated in equity market volatility, e.g. during the fourth quarter of 201818. With the Fed’s strategy shift pushing back the likely timing of any future rate hikes, the risks from such a headwind have similarly been postponed. Negative real yields on bonds and ongoing liquidity creation via quantitative easing should be supportive of equity valuations. Moreover, a further weakening of the US dollar would boost the overseas earnings of US companies, while also reducing funding costs for non-US companies that have borrowed in US dollars.
The actual delivery of a moderate inflation overshoot could have implications for sector performance within the equity market. Stronger nominal GDP growth that lifts corporate earnings could broaden the rally in equities, which in recent years has been led by so-called ‘growth’ sectors, most notably the big US tech companies. As prices for commodities tend to do well in higher inflation environments, the performance of companies in the materials sector should improve as inflation picks up19. In addition, higher long-term bond yields and a steepening of the yield curve resulting from increased inflation expectations could support banks. More generally, companies with strong pricing power that are able to pass on increased costs to consumers are likely to fare better than those that cannot.
On the whole, a shift to an environment of moderately above-target inflation in the US would carry significant ramifications for financial markets. There is understandable scepticism that, by itself, the Fed can pull off such a feat. However, if the November election ushers in a Democratic administration that significantly boosts government spending and increases the bargaining power of workers, the odds of the Fed meeting its goal could increase dramatically.
18 September 2020
This article is for generic information only and is not suggesting a suitable investment strategy for you. You should seek independent financial advice that takes your individual circumstances into account prior to proceeding with any course of action.