Well, yesterday the Fed, represented by its head Jeremy Powell, formally confirmed that it adjusts reaction function to changes in inflation. Whereas previously the Fed used to target specific rate of inflation (2%), new framework implies average inflation targeting.
The decision was widely expected, but I would like to make a few remarks about why that was necessary and how it could affect expectations on tentative dates of policy normalization.
According to the Fed’s report entitled “Review of The Monetary Policy “, the decision is based on the fact that the US is entering a “new normal”, which is characterized by the following observations:
- Productivity (output per worker) continues to decline, and the population is aging.
- The hypothetical neutral interest rate (at which GDP and inflation grow at a stable rate) is decreasing which implies that you need less interest rate hikes to get to the desired level.
- Increasing the workforce (i.e. the level of labor force participation) should become a priority. By the way, the last decade of monetary stimulus was able to inflate many nominal indicators and raise some real indicators, but it was the LFPR that mysteriously remained at low levels, and drifted even lower during the pandemic:
The crucial importance of LFPR in driving inflation can be demonstrated with the following hypothetical example: Suppose unemployment level is 0% which is associated with extreme economy overheating and thus inflation. If LFPR is low, for example 30%, only 30% of the working population will get paid and feed inflation through spending. In this case, contrary of our expectation of high inflation, we may barely see its move towards a target level.
- A related issue with point 3 is that jobless rate sufficient to generate desired level of inflation decreases over time. Unemployment of 4% now and 10 years ago are clearly different in terms of potential to create inflation pressures.
Now let’s discuss the Powell speech.
The first thing that sticks out is extremely vague definitions. “Moderate” inflation overshoot over 2%, “period” during which inflation will average 2% … What does “moderate” mean in quantitative terms? When this very “period” will start, when it should end – all this remained unclear. According to Powell himself, there won’t be “mathematical formula”, everything will be very flexible (i.e. at the discretion of the Fed). The new framework is clearly a progress towards greater flexibility. We didn’t get nothing concrete except for the strong feeling that in the next 6+ years the rates will be likely near zero. But why? Firstly, from June FOMC projections we know that for the next three years, Central Bank officials expect the interest rate to stay at current level, and Core PCE below 2%:
Second, if we recall how long inflation stayed above 2% in the last decade after massive easing and fiscal stimulus…
… we can conjecture that pursuing average inflation of 2% without additional stimulus may require quite wide period which extends beyond 2030.
Hence, the bond market reaction to the Powell speech was mainly concentrated at the far end of the yield curve – the yield on long bonds rose, as the risks of increased inflation in the longer term increased. In the closer parts of the yield curve, there was less news from the speech, so the reaction wasn’t so strong.
The main conclusion from Powell’s speech is that rates will remain at a low level for a longer time. It is a key ingredient in further, sustained declines in US real yields, a powerful driver of USD depreciation and Gold gains that have already shown its potential this year.
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