Perspective

What the Fed’s new target means for inflation


Despite changing its policy framework with the introduction of an average inflation target (AIT) and aim of maximum employment, the US Federal Reserve (Fed) took no action at its latest policy meeting.

Interest rates and asset purchases remain unchanged, although the central bank did give a steer on how its new policy would work going forward.

A change in approach

The Fed refreshed its Summary of Economic Projections, which forecasts how growth, interest rates, inflation and unemployment will develop in the years to come. Its inflation forecast was notable, as it showed inflation moving back up to 2% in 2023.

That this came alongside no change in projected interest rates marks a departure from the past. Previously, the Fed would have signalled a tightening of policy in response to such an outlook. The new policy means that the Fed is willing to wait until inflation has gone above 2% until it responds.

Although we do not as yet know the time period over which the Fed intends to hit an average inflation target (AIT) under its new framework, an average of the last four economic cycles (as measured by the National Bureau of Economic Research) comes in at just under ten years.

On this basis, the current 10-year inflation average of 1.6% implies a significant period of inflation above 2% to hit the AIT. Clearly, all things being equal, monetary policy will have to be looser if the Fed were aiming to bring inflation back to 2%.

Will the Fed be able to generate higher inflation?

In the near term, the Fed’s options are limited as monetary policy is already very loose. Fed chair Powell has ruled out using negative interest rates, so any tweaks would be to forward guidance or asset purchases (QE). But essentially, we are close to maximum stimulus.

The difference will be further out as policy will now stay loose for longer as growth recovers and the economy is allowed to “run hot” for a period to try and generate higher inflation. Interest rates will stay lower and QE continue for longer than under the previous framework.

This may create higher inflation, but as we saw before Covid-19 struck, even with unemployment at 50-year lows it has been difficult to generate 2% inflation. Low unemployment no longer sparks increases in wages or price inflation and, as has been widely observed, the Phillips curve has flattened.

Inflationary trends at play

The Fed’s policy tools have clearly lost much of their power since the global financial crisis as households have de-leveraged and banks have become more heavily regulated. However, fiscal policy should still be effective. Whilst this is the remit of government rather than central banks, the latter can encourage the former to be more aggressive on the fiscal front through keeping bond yields along the curve low and allowing a higher sustainable level of government borrowing. This has already been achieved through forward guidance and QE, it could be ultimately supplemented by yield curve control where the Fed simply sets the yield on the 10-year bond.

Looser fiscal policy could then create excess demand and inflation. This theme could become even more significant should governments move toward policies advocated by the Modern Monetary Theory (MMT) school of economics, where expenditure is directly funded through money printing. However, this would require a regime change and would be in the long term rather than near or even medium-term horizon. 

More easing in near term?

The Fed chose not to move and it has its work cut out in meeting the new AIT, especially in the near term as the downdraft from the recession will weigh on inflation. This may mean we see more easing by the Fed in the coming months and the possible introduction of yield curve control at least for a period.

 

Important Information
Any security(s) mentioned above is for illustrative purpose only, not a recommendation to invest or divest.
This document is intended to be for information purposes only and it is not intended as promotional material in any respect. The views and opinions contained herein are those of the author(s), and do not necessarily represent views expressed or reflected in other Schroders communications, strategies or funds. The material is not intended to provide, and should not be relied on for investment advice or recommendation. Opinions stated are matters of judgment, which may change. Information herein is believed to be reliable, but Schroder Investment Management (Hong Kong) Limited does not warrant its completeness or accuracy.
Investment involves risks. Past performance and any forecasts are not necessarily a guide to future or likely performance. You should remember that the value of investments can go down as well as up and is not guaranteed. Exchange rate changes may cause the value of the overseas investments to rise or fall. For risks associated with investment in securities in emerging and less developed markets, please refer to the relevant offering document.
The information contained in this document is provided for information purpose only and does not constitute any solicitation and offering of investment products. Potential investors should be aware that such investments involve market risk and should be regarded as long-term investments.
Derivatives carry a high degree of risk and should only be considered by sophisticated investors.
This material, including the website, has not been reviewed by the SFC. Issued by Schroder Investment Management (Hong Kong) Limited.