The Federal Reserve (Fed) convened in August at the Jackson Hole Economic Symposium and again in September. Both meetings resulted in questions we hope to answer. Our latest blog highlights the ones we believe are on top of investors’ minds and key takeaways.
What was the key takeaway from the Jackson Hole Economic Symposium?
The Fed announced they would operate under a new monetary policy framework called Flexible Average Inflation Targeting (FAIT). The FAIT strategy adopts a flexible approach to achieving an average 2% rate of inflation while avoiding pre-emptive rate hikes to counter perceived inflation risk associated with a falling unemployment rate.
What changes did the Fed make at the September FOMC meeting?
The Fed introduced three new criteria to its forward guidance that will determine when they will move the Fed funds rate off the zero lower bound: 1) Maximum employment; 2) PCE inflation at 2%; 3) Future inflation that is on track to moderately exceed 2% for some time.
Maximum employment does not relate to a specific level of unemployment. The Committee has grown skeptical of models that suggest raising rates at a pre-determined percentage of headline unemployment. Instead, the labor market will be evaluated holistically by looking at a number of different metrics. The Fed has highlighted the benefits from running a hot labor market and likely yearns to restore the level of unemployment to its pre-COVID low of 3.5%.
On inflation, the Fed will need to feel comfortable that when it reaches 2% that the rise has not been driven by transitory factors. For example, we inevitably expect to see a transitory increase in inflation next year driven from the base effects of weak inflation readings from the pinnacle of the COVID crisis.
What does this new framework (FAIT) and forward guidance mean for monetary policy historically?
In the most recent hiking cycle, the Fed raised rates for the first time in December 2015. At the time, core PCE was at 1.2% on a year-over-year basis. The unemployment rate had fallen to 5%, approaching prior estimates of Non-Accelerating Inflation Rate of Unemployment (NAIRU), guiding the Fed towards rate hikes. The Fed proceeded to hike five times before core PCE reached 2% in 2018. Inflation did not spend much time above 2% and soon dropped lower as the US-China trade war heated, global exports rolled over and the Fed began normalizing its balance sheet. Applying the current FAIT framework to the last hiking cycle, the Fed would have delayed raising rates for at least three years. Had they pushed out the lift-off date, the economy would have operated with a hotter labor market sooner and recovered more quickly. In hindsight, we now know that inflation risk was not as pressing as the Fed’s models suggested.
While the facts of today’s economy make FAIT an attractive solution, analyzing monetary policy decisions using this framework in periods prior to the Great Financial Crisis (GFC) is more complicated. For example, the neutral rate of interest (the Fed’s measure of an equilibrium policy rate) has fallen over 200 basis points (bps) since the Fed first started publishing a forecast in 2012 while the Phillips curve relationship between unemployment and inflation has weakened. The decline in the real neutral rate, a flatter Phillips curve and low inflation expectations constrain the ability for the Fed to ease monetary policy. Therefore, a new policy approach is needed in order to help stimulate the economy while operating under these constraints.
What did the dot plot show after the September FOMC meeting?
In short, easy money is here to stay for the foreseeable future.
The dot plot showed unemployment moving lower to 4% and inflation returning to 2% by 2023 while the Fed funds rate was projected to remain at the zero lower bound through the entire forecast horizon. With the neutral Fed funds rate at 2.5%, this suggests the Fed will be providing significant accommodation even beyond the point at which inflation starts to tick up toward its objective. This is consistent with guidance in the September statement that suggests policy will remain easy, even after lift-off, until inflation averages 2% and expectations are anchored around 2%.
Can we expect the Fed to get inflation to average 2%? What will drive inflation going forward if the Phillips curve relationship is no longer a meaningful one?
It’s reasonable to be skeptical. Since 2000, year-over-year core PCE has spent just 25% of the time above 2% and only 5% of the time above 2.25%. That said, what may be different and a big swing factor this time is the potential for additional fiscal policy. While COVID-19 is a disinflationary force due to its negative impact on economic activity, the unemployment benefits provided in the first CARES act contained shades of universal basic income (UBI). This allowed lower income unemployed workers to maintain their prior pace of spending and increase summer expenditures while still having residual savings! Should Congress agree to more stimulus, coupled with an eventual (hopefully) vaccine, it is reasonable to think that a torrent of pent up demand could be unleashed, thus stoking a level inflation not seen for some time.
The challenge with this observation is that it is purely theoretical. While it sounds plausible that in a scenario where a vaccine combined with aggressive fiscal stimulus targeted towards individuals with a higher tendency to spend rather than save would spark newfound consumption, we have little empirical evidence to support this. Some economists draw parallels to the 1960s, but in this regime, it took over a decade for the inflationary forces to build. Furthermore, the high levels of inflation were propelled by an energy shock that monetary policy was unable to control. Lastly, there was no 2% target at the time, and it was not commonly accepted theory that inflation expectations were crucial to influencing realized outcomes.
What about financial stability? Is the Fed concerned that FAIT will lead to asset bubbles?
To cut to the chase: the answer appears to be no, at least for now.
Chair Powell provided a clear response to this question, which was posed multiple times during the press conference. Should financial stability become an impediment to the Fed’s goals, it will tackle any problems through regulation and macro prudential tools (stress testing, capital requirements, etc). Monetary policy will not be the first line of defense.
What can the Fed do if the economy slows again or inflation drifts lower?
The next action we expect from the Fed is likely an adjustment to their quantitative easing program (QE). In a subtle shift in the September statement, the FOMC modified its description of QE to include the ability to target broad financial conditions, as opposed to solely emphasizing market liquidity, which was the priority at the start of the crisis. The result is a shift that is more consistent with prior QE programs. If the Fed continues to stay on this track, they may also consider altering the weighted average maturity of its purchases, like past QE cycles. While they have had success promoting the housing recovery though lower mortgage rates, the spread to 30-year Treasury yields remains elevated enough that the Fed may want to put further downward pressure on long dated borrowing costs.
The timing of an adjustment to their QE program is likely dependent on fiscal policy. The impulse from the CARES act is fading and it is not yet clear if another stimulus bill will be passed before the U.S. presidential election. The strength of the recovery thus far has exceeded the Fed’s expectations, but they are bracing for the risk that fiscal policy turns from a positive influence to a negative one. Should economic data start to slow and Congress fail to take action, the Fed will be forced back on their front foot sooner rather than later.