What does it all mean?
In our view, the Federal Reserve (the Fed) is seeking to stress its commitment to growth. Official interest rates will be low for a long time and the Fed will no longer pre-emptively tighten interest rates, even in response to future fiscal expansions. However, the prospect of yield curve control (YCC) being deployed in the foreseeable future appears to have considerably receded.
What is new?
The Fed discarded the idea that unemployment can fall too low. From now on the Federal Open Markets Committee (FOMC) will talk about ‘shortfalls’ rather than ‘deviations’ from full employment. A low unemployment rate will, on its own, no longer be enough to justify raising official policy rates, as it was during the 2016-18 period.
What is missing?
There was no discussion about the monetary policy tools (such as quantitative easing (QE), yield curve control) the Fed could use to hit its new objectives. This omission is the most likely explanation for the bond markets somewhat subdued reaction to what appears, at first view, like dovish news. It remains to be seen if the absence of any comments about the policy toolkit is a sign the Fed has now abandoned any intention of undertaking yield curve control. A similar fate befell the idea of negative policy rates. The fact yield curve control was not addressed today suggests to us that it may now be off the Fed’s policy agenda.
What came out as expected?
FAIT - A somewhat fuzzy form of average inflation targeting - the Fed will aim to have inflation run ‘moderately’ above 2% for a while after it has been below 2%.
What’s next for the Fed?
There will be an expectation that Chair Powell addresses the policy implications of this framework change at the mid-September FOMC meeting. The odds that we will get new forward guidance about what has to happen before the Fed will consider hiking plus detail on the future path for QE in September has gone up (instead of being delayed to the November meeting).
Looking at the detail…
Chair Powell used his speech at Jackson Hole to unveil the main conclusions of the Fed’s strategy review. He confirmed that the Fed will encourage/tolerate a rate of inflation slightly above 2% in the later stages of the business cycle to counteract the tendency for (core) inflation to run below 2% when the unemployment rate is elevated. This was widely expected, what is surprising is the re-interpretation of the employment part of the Fed’s dual mandate and the Chair Powell’s failure to spend any time talking about the Fed’s policy toolkit, suggesting no new tools (yield curve control for example) will be forthcoming.
Monetary policy tools and their use
Some observers expected Chair Powell to spend some time discussing the set of policy tools the Fed has available to it, although not to go so far as to actually announce policy changes (such as to the forward guidance and current pace of QE). But he was silent on this issue. One, somewhat speculative, interpretation of this silence is that the Fed has decided against using yield curve control. It may be that they did not want to evoke this yet as they have not yet finished refining their forward guidance and QE programmes. Ruling out yield curve control without also reinforcing other monetary instruments risked an unwanted bond market tantrum.
Governor Brainard is speaking on 2 September. She has been one of the key advocates on the FOMC of yield curve control. If she does not continue to push for it in her remarks, then it will increasingly look like it will take a large market reaction (e.g. a taper tantrum 2.0) in order to pull the FOMC back toward the idea of using it.
Lurking unsaid is the fact that the key determinants of the pace of the recovery in 2021 and beyond are not in the hands of the Fed. They are the efficacy and speed of distribution of a vaccine and the stance of fiscal policy.
Historically the Fed has relied upon the concept of a natural rate of unemployment as the key to judging whether the labour market is at risk of overheating and putting upward pressure on inflation. But the natural rate of unemployment is not a metric like retail sales or the rate of inflation, it’s not something you can go out and measure, you have to infer its value using some form of macro-economic model.
Throughout the last tightening cycle, critics of the Fed argued that the FOMC’s view of the amount of spare capacity in the labour market was too conservative (i.e. the natural rate of unemployment was lower than the Fed believed) and that the Phillips curve relationship between unemployment and inflation was too uncertain to be the cornerstone of monetary policy. As time passed and the unemployment rate continued to decline without a commensurate increase in inflation, the force of those arguments became stronger. Eventually in October last year, Chair Powell essentially gave into them, saying that he would need to see ‘a really significant move up in inflation that’s persistent before [he] would consider raising rates’.
Today’s change to the description of full employment as something the economy falls short of from time-to-time, but never exceeds, is one facet of formalising that thinking. The Fed now has an asymmetric approach to the labour market. When the jobs picture is bleak – as now – they will cut policy rates aggressively, but they will not tighten just because the unemployment rate is low. Had they followed this strategy through 2016-18 there would arguably have been far fewer (no?) rate hikes than the nine that occured (four of those under Chair Powell’s watch), as the Fed stood guard against a perceived risk of inflation.
Average inflation targeting
It was almost universally expected ahead of yesterday’s meeting that the Fed would adopt a loose form of average inflation targeting. It did.
Powell said the Fed will “seek to achieve inflation that averages 2% over time. Therefore, following periods when inflation has been running below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2 % for some time. In seeking to achieve inflation that averages 2 % over time, we are not tying ourselves to a particular mathematical formula that defines the average. Thus, our approach could be viewed as a flexible form of average inflation targeting”.
As with the changes to the employment side of the mandate this redefinition of price stability has no immediate implications for policy. Those consequences won’t become apparent for several more years, once the business cycle is mature. Indeed since the Fed has said it will conduct another policy framework review in five years’ time, if the recovery is sluggish, the next policy review will come along before the Fed has an opportunity to demonstrate its commitment to the outcome of this one: allowing inflation to overshoot 2%.
Here is some perspective from former Chair Janet Yellen talking to reporters after yesterday's announcement:
“It seems like a pretty subtle shift to most normal human beings, but most of the Fed’s history has revolved around keeping inflation under control. This really does reflect a decisive recognition that we're in a very different environment.”
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