The Fiscal Elephant in a Monetary Room
For investors, while the announcement does provide further clarity on future Fed action, it does not suggest any changes are warranted in portfolios currently.
Listen to On the Minds of Investors
The Federal Open Market Committee officially announced an update to its Statement on Longer-Run Goals and Monetary Policy Strategy. Most notably, the committee has officially adopted an average-inflation targeting framework, in which the committee will allow inflation (as measured by the core personal consumption deflator) to run moderately above 2% for a period of time following a period of inflation persistently falling below 2%. While many participants had been expecting some commentary from Chairman Powell on the status of the committee’s policy review, few expected a formal announcement would be made this soon, given the July minutes suggested committee members were still some time away from finalizing their review.
For investors, there are some key takeaways. First, the announcement provides an update to the Fed’s framework, we still expect this enhanced forward guidance to lead to further outcome-based forward guidance by the end of the year. This will allow the committee to further clarify the time horizon over which it seeks to achieve an average 2% inflation rate, the upper-bound range or level the FOMC is comfortable inflation running when above 2%, and the pace and size of interest rate hikes associated at and above these levels.
Second, the committee no longer views inflation as a symmetric target and clearly sees greater risks to low inflation, rather than higher inflation. In fact, the committee removed the language around its inflation target being symmetric altogether, further acknowledging that super easy monetary policy through most of the pre-COVID expansion frustratingly did not lead to higher inflation.
Third, the Fed, to a certain extent, is running out of options. While the policy shift is welcome, it casts a bright light on the difficult macroeconomic environment the FOMC is dealing with. It is clear that prolonged periods of near-zero interest rates and aggressive quantitative easing alone are not enough in achieving 2% inflation, let alone inflation above that level. With this in mind, the Fed can only really lean on forward guidance, hoping to firm inflation expectations, while not causing financial market stress.
Lastly, it should be recognized that while the Federal Reserve conducts monetary policy independently, the real power of monetary policy, in 2020, is through debt monetization, not through low interest rates. Government stimulus that can effectively be financed through an interest free loan from the central bank encourages increased deficit spending and would likely generate the inflation the Fed is targeting. Of course, the Fed would never acknowledge this as it would erode its own independence and potentially weaken the perceived effectiveness of its own policy tools. Nonetheless, the two forces in tandem would be a powerful impetus for higher prices.
Elsewhere, the committee adjusted the language to its objective of maximum employment. The committee’s policy decisions will now be based on the assessment of the “shortfalls on employment from its maximum level” rather than deviations. The change in language suggests it recognizes that even a remarkable improvement in the labor market as experienced over the last expansion, may not generate much inflation. Moreover, monetary policy serves as a rather blunt instrument in influencing labor market conditions without fiscal measures also, another subtle acknowledgement for the need of government support in achieving its goal.
Overall, we think the Fed’s actions are a step in the right direction. The Fed has been extraordinarily proactive in their handling of monetary policy in the current environment and its announcement shows the committee continues to be forward thinking in their approach. There are still questions, however, if this approach will be successful in actually firming expected and realized inflation at 2% with its current toolkit.
For investors, while the announcement does provide further clarity on future Fed action, it does not suggest any changes are warranted in portfolios currently. Inflation is likely to rise, albeit gradually as the economy navigates a bumpy reopening process. Short term rates are likely to remain near zero well into 2021, while long yields should move gradually higher as growth stabilizes. With that said, as equites continue to reach all-time highs on shaky fundamentals, some degree of protection should still be in place.