Average-Inflation Targeting in a Washington without Hawks
Washington Hawks flourished in the late 1970s and 1980s, when deficits and inflation were seen as significant threats to the nation. However, their numbers have dwindled in recent years due to persistent low inflation and the rise of populism.
For many years, the Washington Hawk has been on the brink of extinction.
As background for those younger investors who have never seen a Washington Hawk, it has historically come in two varieties, the Monetary Hawk and the Fiscal Hawk. A good example of a Monetary Hawk was Fed Chairman, Paul Volker, who raised the federal funds rate to 20% in the early 1980s, plunging the economy into recession in a successful war against inflation. Fiscal Hawks included notables such as Senators Phil Gramm, Warren Rudman and Fritz Hollings who sponsored landmark legislation in 1985 designed to eliminate the federal deficit by 1991.
Washington Hawks flourished in the late 1970s and 1980s, when deficits and inflation were seen as significant threats to the nation. However, their numbers have dwindled in recent years due to persistent low inflation and the rise of populism. The current pandemic recession appears to have dealt a death blow to the species and its traditional habitat has now been taken over by swirling flocks of red and blue doves.
The supremacy of monetary doves should be on full display this week at the Fed’s annual Jackson Hole retreat, which will be conducted virtually this year. On Friday morning, Fed Chair, Jay Powell will make some comments on the Monetary Policy Framework Review, which the Fed has been conducting since 2018. It is likely that he will speak approvingly of the concept of “average-inflation targeting” and that this will be included in an updated version of the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy following the conclusion of the September FOMC meeting on September 16th.
The Fed has a long-term objective of achieving 2% inflation as measured by the personal consumption deflator. However, in recent years the actual inflation rate has consistently undershot this target and this appears to have led to a reduction in inflation expectations among workers, consumers and investors. One problem with this is that low expected inflation can beget low actual inflation, as wage and price increases are set based on subdued expectations. One proposed solution to this, broadly known as average-inflation targeting, is to deliberately let inflation run hotter than its 2% target for a period to allow inflation expectations to rise. One way this policy could be implemented would be by trying to achieve this average inflation goal over a fixed period of time, as noted in a recent article by economists at the San Francisco Fed.
For example, year-over-year consumption deflator inflation has averaged 1.5% over the past three years. An average-inflation targeting regime could aim for 2.5% average inflation over the next three years. If this was achieved, then the economy would have averaged 2% inflation over a six-year period and the public might will adjust its inflation expectations to roughly 2%.
Of course, even if Fed does adopt some version of average-inflation targeting, many investors may doubt their ability to raise the inflation rate above 2% in order to achieve it. After all, central banks around the world have consistently failed to raise inflation over the past decade despite very easy monetary policy, expressed largely in the form of near-zero interest rates.
However, it is crucial to recognize that the Fed’s efforts to boost inflation going forward won’t need to rely on low short-term interest rates alone. Since the onset of the coronavirus pandemic, the Federal Government has adopted an extremely expansionary fiscal policy and the Federal Reserve has enabled this policy, essentially through massive debt monetization. Indeed, since the start of the year, the Federal Reserve has financed $2 trillion of the massive $3.5 trillion expansion in the public debt.
While monetary stimulus, operating on its own through the medium of low long-term interest rates is a fairly feeble tool in boosting either demand or inflation, it can be very powerful if it enables the Federal Government to cut taxes and increase spending almost without limit, particularly if fiscal policy is focused on increasing incomes for lower and middle-income households and continued once the economy is otherwise reasonably healthy.
Of course, the economy remains far from healthy today.
Data due out this week should show a some further recovery from the coronavirus recession but still with very significant slack. In particular, continuing Unemployment Claims are likely to remain above 14 million, down from a peak of almost 25 million in early May but more than double the 6.6 million seen in the worst week following the Great Financial Crisis. In addition, Real Consumer Spending for July should see a year-over-year decline of roughly 4.5% year-over-year, as an almost 5% bounce in consumer spending on goods is swamped by a 10% decline in services. Inflation data should continue to reflect this slack with year-over-year Consumption Deflator inflation rising from 0.8% in June to 1.0% in July, still far short of the Fed’s current 2% target.
However, long-term investors should consider how the policy landscape will likely look after the election and the pandemic. Fiscal policy is likely to be very expansionary under either party, as there now appear to be no fiscal hawks among either the Democrats or the Republicans. Moreover, as the pandemic ends, pent-up demand for services should generate very strong economic growth, potentially absorbing economic slack much faster than in previous expansions. While this would be positive for the stock market it could also push inflation well above 2% in 2022.
While this would be in line with the Fed’s new average-inflation targeting plan, there is a risk that inflation could rise further, beyond a range that the Fed feels comfortable with. If, at that point, the Fed applies the brakes by refusing to further increase the size of its balance sheet or even tapering its holdings of Treasuries, long-term interest rates could rise fairly sharply. This would clearly be a negative for long-term bonds and possibly for growth stocks relative to value stocks.
While many may doubt the ability of the Fed to raise the inflation rate after so many years of falling short, investors need to recognize the change in the Washington environment. The disappearance of both monetary and fiscal hawks suggests that, in a best case scenario, average inflation targeting will succeed and that in a worse case outcome it will fail not by undershooting an average inflation target but by overshooting it. Either way, investors should prepare themselves not just for higher inflation but for higher interest rates in the years ahead.
 “Average-Inflation Targeting and the Effective Lower Bound”, Renuka Diwan, Sylvain Leduc and Thomas M. Mertens, FRBSF Economic Letter, August 10th, 2020