Federal Reserve Updates Permissible Inflation: Markets find upbeat logic in the new policy

• Fed announces shift to “average inflation targeting” from a specific rate.
• Goal is to permit periods of higher inflation to balance lower.
• Practical effect is lower rates for even longer.
• Equities, credit yields and the dollar rise as policy offers no immediate changes but a better outlook.

The Federal Reserve adopted a new inflation policy that that will permit price increases above the 2% target for extended periods if necessary to balance periods of weak performance.  

A product of the much discussed Monetary Policy Review, which has been more than a year in the making, the change reflects the bank’s experience with inflation and unemployment since the financial crisis.

The FOMC will now seek to produce an average core inflation rate over time rather than attempting to manage price changes within a narrow band around a set goal. 

"Following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time," said the FOMC statement.

Maximum employment

This practice will give the bank more flexibility in pursuing its Congressional mandate for maximum employment.  

That goal received an update as well with language noting that the employment level will be judged by “assessments of the shortfalls of employment from its maximum level,” as opposed to “deviations” from the maximum level.

While the different language seems trivial, the fact that it is new gives the Fed the ability to redefine its policy interpretation of the relationship between low unemployment and wage inflation.

“This change reflects our appreciation for the benefits of a strong labor market, particularly for many in low- and moderate-income communities,” said Mr. Powell. “This change may appear subtle, but it reflects our view that a robust job market can be sustained without causing an outbreak of inflation.’

Under Chairman Powell employment has become the fount of Fed policy. The economic and social benefits of low unemployment, particularly for African-American and Hispanic communities, have been praised by the Chairman and other Fed officials on numerous occasions

Employment and inflation

The central bank had long considered a tight job market as the precursor to wage and then price inflation.  Traditionally, as unemployment sank below 4% policymakers began to move to a rate tightening cycle even if there was no sign of rising prices or wages.

Practical experience over the 12 years since the financial crisis has helped modify that view and also the interplay between quantitative easing liquidity and price inflation.

As the unemployment rate dropped below 5% in October 2016 and then 4% in May 2018, long seen as the neutral rate of unemployment below which wage inflation must begin, inflation remained quiescent.

The unemployment rate was below 4% for 19 of 21 months until February 2020 and for a record 13 straight months to the onset of the pandemic in March but inflation did not appear.

That recent evidence confirmed the quantitative easing data of the previous decade. Despite several rounds of credit market purchase and a quadrupling of the Fed balance sheet between late 2008 and 2014, inflation barely moved.  At no time did it make a sustained push above the 2% target.  Not until almost five years after the purchases stopped did inflation approach the target averaging 1.96% in 2018.

Based on this experience and now codified as policy, the FOMC will be far less inclined to consider raising rate based solely on a drop in the unemployment rate. 

Reuters

Market response

Everyone found something to like or ignore in the Fed’s new policy. 

Equities added to their near record levels with the Dow rising 160.35 points, 0.57% to 28,492.27 briefly going positive for the year and the S&P 500 edging up 5.82 points, 0.17% to 3484.55.

With inflation well below the Fed’s 2% goal the new policy means that even if prices begin to accelerate the FOMC will be in no hurry to raise the fed funds rate as a prolonged period of above target price increases will balance the prior time of weak gains. Thus lower rates for longer.

Currency markets at first sold the dollar sharply with the euro rising briefly above 1.1900. But traders quickly reversed those positions realizing that the policy promised no rate changes for the foreseeable future and with the US economy showing signs of sustained improvement the fate of the dollar would be determined by payrolls and unemployment. Thus lower rates for longer is well beyond the currency markets trading horizon.

The gain in longer Treasury yields, the 10-year rose 6 points to 0.746% and the 30-year added 9 points to 1.5%, reflected the long term view that the US recovery is stable enough to promote higher inflation even a policy response if distant.    

If the US economy continues to regain its verve, July durable goods orders more than doubled forecasts at 11.2%,  the next predictable move in rates, even if delayed by the new policy on inflation, would be higher yields and lower bond prices. With rates not far from their record lows and prices near their highs, there are a great deal of bond market profits to consider.  

On a psychological note it was probably reassuring for the markets to hear from the Fed on something other than the pandemic.  If the bank is preparing for the return of inflation, perhaps it is no longer so worried about the present