What does the Fed’s latest change in monetary policy framework mean for Asian investors?
The Federal Reserve (Fed) announced on August 27 that it will adopt a new monetary policy framework. It will move to an average inflation target of 2%. If inflation has been below this target, the Fed will be willing to tolerate a period of above 2% inflation to achieve this average target. The Fed has acquiesced to the idea that the job market could stay strong without leading to a surge in inflation. The announcement was not a complete surprise, since the Fed has been transparent in this review for some time. It was a little earlier than expected since most investors expected this to be discussed in more detail in the upcoming Federal Open Market Committee meeting on September 15-16.
The Fed’s latest change in monetary policy framework is a move to leverage its credibility to boost inflation expectations and generate appropriate price movements. Expectations for where inflation will be in the future can be heavily influenced by where inflation has been in the past. Given that the Fed’s inflation target has fallen short for a number of years, it may be difficult to convince the market and investors otherwise in the long run. Ideally, businesses and individuals would anticipate higher inflation in the future and incorporate this into their investments, pricing and wage decisions. It then becomes a self-fulfilling prophecy for inflation to pick up. It remains to be seen whether this would achieve the Fed’s goal. Inflation in the U.S. has stayed low despite an extended period of zero interest rates after the global financial crisis. The Fed isn’t alone, the European Central Bank and Bank of Japan have adopted negative interest rate policies and aggressive asset purchases in the past decade, but inflation has failed to return to their targets. There are structural factors that drive prices other than the level of interest rates, such a demographics and global trade trends.
Investors are still waiting for more details on how exactly the new framework will be applied, such as the time period used in calculating the average and at what point would higher inflation trigger a policy response. September will see the release of a new round of economic projections and the ‘dot plot’ by the Fed. However, new metrics for forward guidance may render the old marker posts, such as the ‘dot plot’, irrelevant. Similarly, the experience of a very low unemployment rate without wage and inflation pressures (a flatter Philips Curve) at the end of the last cycle means that the Fed will likely push the economy to full employment and keep it there before pre-emptively raising rates. The Fed did acknowledge in the statement that monetary policy is constrained by their effective lower-bounds because of the persistently low rate environment. This means the Fed is unlikely to cut rates below zero, but instead relies on a broader set of tools to achieve its policy objectives.
Given that the U.S. economy has seen its inflation running below target for an extended period of time, the latest shift implies the Fed is more tolerable of inflation running hot and holding back on tightening monetary policy, including reducing asset purchases and raising interest rates. The core personal consumption expenditures deflator, the Fed’s preferred measure for inflation, averaged 1.7% in the past five years and only breached above the 2% target for three quarters during this period.
One important implication is that U.S. monetary policy is going to stay accommodative for even longer. The most urgent task is for the Fed to keep supporting the economy from the pandemic’s fallout. As and when the economy is back to a stronger recovery path, once COVID-19 is overcome, the Fed will also tolerate higher inflation for a period of time before reaching for the brakes. Fiscal policy will also play a critical role in stimulating the economy and the Fed is expected to contribute by maintaining its asset purchase program in buying government bonds.
EXHIBIT 1: UNITED STATES: INFLATION
We will continue to monitor the shape of the yield curve as a gauge of market confidence on this new framework. A steeper yield curve with the long term yields rising would indicate that investors believe the Fed would achieve stronger growth and higher inflation in the long run. Nonetheless, short term interest rates are likely to be anchored around zero since the economy is still under pressure from the pandemic.
Since the Fed is expected to keep rates lower for even longer, as well as employ a range of policies to achieve its inflation target, our constructive view on risk assets, such as equities and corporate debt, is reinforced.
Our emphasis for income generation in the past few quarters remains unchanged. In fixed income, corporate credits and emerging market fixed income should benefit, especially if the global economy is expected to gradually recover in the next 1-2 years. Other sources of income would include high dividend equities. Even though the earnings recession is pressuring dividend payout, we still see opportunities in more defensive companies providing more consistent dividends. Alternatives assets, such as infrastructure, real assets and real estate, could also offer income opportunities.
Low U.S. dollar interest rates would also pressure the greenback to depreciate and this traditionally prompts capital flow into Asian and emerging market assets, both equities and fixed income.