• Federal Reserve Chair Powell unveiled a change in the Fed’s monetary policy strategy, announcing that it will target an inflation rate “that averages 2% over time” (instead of a strict 2% goal), and that it will be concerned with shortfalls of employment from its maximum level (rather than deviations). Taken together, these mean a bias to keeping rates on hold well after economic recovery sets in.
  • Personal income and spending data this week showed continued, albeit slowing progress in recovering from the pandemic-induced shock earlier this year. Real personal spending rose 1.6% in July down from 5.7% in June. Total spending is still 4.9% below its pre-recession peak, with the deficit entirely due to spending on services.

This Weeks Market Data



Federal Reserve Flips the Script, Targets Average Inflation

Financial News- Chart 1It’s not easy being a central banker. The job of the Federal Reserve – to keep the economy and inflation on an even keel with just its power over the monetary printing press – has been made a lot more difficult by the unprecedented global pandemic. While lower interest rates certainly help, as evidenced by the strong rebound in activity in the auto and housing market, there is still a large hole to fill in other areas of spending less sensitive to interest rates. Things like food services and accommodation, healthcare, and recreation services, which together make up 90% of the deficit in spending relative to January of this year, will not return to normal as long as the virus threat remains. Until they do, employment will remain impaired.

It’s not just the health crisis that has complicated the Federal Reserve’s task of achieving maximum employment and price stability (which it interprets as an inflation rate close to 2%). Its traditional policy lever – the fed funds rate – is consistently impaired by the effective lower bound. Once it cuts to near-zero, it must turn to less traditional tools such as large scale asset purchases. At the same time, the relationships between economic variables that it relied on to achieve its mandate appears to have weakened. A hot labor market does not seem to put upward pressure on inflation the way it seemed to in the past.

Faced with challenges to achieving its goals, the Federal Reserve has decided a chance of tack is necessary. Nothing too revolutionary of course, but a recognition that it should be more concerned with employment undershooting its goal than outperforming it. At the same time, having consistently over-predicted the future path of inflation over the past decade, it has come to the view that it should be less concerned about overshooting its 2% objective. So, rather than targeting a forecast of 2% inflation, it will target a rate that includes the recent past – an average inflation target. In other words, if inflation has underperformed, due, for example, to a period of economic weakness, it will not immediately tighten policy even if inflation pushes higher than 2%.

Financial News Chart 2It’s worth unpacking the theory behind this last change. The thinking is that controlling future inflation depends on influencing people’s expectations for it. In order to get inflation up to its (now average) target it has to convince people that its ok being a little behind the curve when it starts to show up. It remains to be seen how effective this can be. Communication will be challenging. People don’t especially like inflation and there will be pressure to tighten policy when the actual rate moves above 2%. The Fed has also not said how much history it is averaging over or how high it will allow inflation to overshoot, simply that it will tolerate it “moderately above 2%.” Will it tighten policy if inflation is at 2.5% or is 3% the more relevant threshold? At the same time, other influences besides expectations may keep downward pressure on price growth. Just because it wants inflation to move above 2% doesn’t mean it will. Just ask the Bank of Japan.

Still, the reaction in markets to the statement has been positive so far. Stock markets rallied on the news. This makes some sense. Taken at face value, the fed funds rate are likely to remain lower for even longer.

James Marple, Senior Economist | 416-982-2557

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