The Fed just de facto increased its inflation target to 2.5%

The long awaited update of the Federal Reserve’s Monetary Policy Strategy has just been announced.

Here are the key points:

  • On maximum employment, the FOMC emphasized that maximum employment is a broad-based and inclusive goal and reports that its policy decision will be informed by its “assessments of the shortfalls of employment from its maximum level.” The original document referred to “deviations from its maximum level.”
  • On price stability, the FOMC adjusted its strategy for achieving its longer-run inflation goal of 2 percent by noting that it “seeks to achieve inflation that averages 2 percent over time.” To this end, the revised statement states that “following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
  • The updates to the strategy statement explicitly acknowledge the challenges for monetary policy posed by a persistently low interest rate environment. Here in the United States and around the world, monetary policy interest rates are more likely to be constrained by their effective lower-bound than in the past.

This is pretty much as expected, but it is nonetheless a significant change relative to the earlier strategy.

Most important clearly is the fact that the Fed has changed its inflation target from a regular inflation target to an ‘average inflation target’.

Under a regular inflation the Fed would let bygones be bygones and if the target has been undershoot or overshoot it would not have implications for the future path of monetary policy. However, under an average inflation target the Fed will try to ‘payback’ if the target has been overshoot or undershot in the previous period.

This obviously is something similar, but not entirely the same as a level target where the Fed would have targeted the price level.

Market monetarists like Scott Sumner, David Beckworth obviously for years have argued that the Fed should implement a NGDP level target. Unfortunately the Fed has not chosen to follow that path, but with an average inflation target we certainly have moved closer so I personally welcome this decision and I believe it will be helpful in securing nominal stability going forward.

The Fed is now de facto targeting 2.5% inflation for the coming years

The Fed has since 2012 had an official 2% inflation target (measured as core PCE inflation). However, the Fed has also consistently failed to hit this target and if we look at 5 and 10 year moving averages of inflation then inflation has been close to 1.5% rather than 2%.

Consequently if we look forward the Fed needs to payback by having inflation above 2% for a sustained period.

The Fed has not said what kind of time interval with will be looking at but i think it would make sense to look at a 5-year moving average.

Average inflation target

Over the past year PCE core inflation has average around 1.5% and if we also assume the ‘payback period’ is five years then this would imply a 2.5% de facto inflation for the coming five years.

If we compare this to market expectation then we see that Fed monetary policy is indeed too tight as 5-year market inflation expectations are presently around 1.6% and if we further correct for the fact that market inflation expectations refers to headline CPI inflation rather than core inflation then the difference is likely a further 0.5%.

breakeven 5-year

Said in another way – if the Fed policy change would be 100% credible we should expect market inflation expectations to jump to close 3%. This hasn’t happened…yet, but let see if Fed chief Jerome Powell dare follow through on his announcement today.

No matter what it is hard not to see today’s announcement has a de facto announcement of further monetary easing from the Fed. Not surprisingly global stock markets have risen on the news and the dollar has weakened. If Powell follow-through we should expect a lot more of that going forward.

And yes, in terms of my forecast that US unemployment will drop below 6% by November this certainly helps.

Leave a comment

4 Comments

  1. Sant

     /  August 27, 2020

    I wouldn’t be so sure, gold and euro have already changed course. A revision to the concept of “symmetric inflation” has been around for more than a year. Nothing really new to see here.

    Reply
  2. Dr

     /  August 27, 2020

    …but the USD has strengthened

    Reply
  3. Justin

     /  August 27, 2020

    The market has not appreciated the gravity of this. If the Fed adds one more piece to this puzzle: a willingness to actively push average inflation to target (level target) through forward guidance or purchases, then we’re talking trillions in incremental, cumulative dollar spending vs the outlook, say, pre-virus. The 5-year TIPS Breakeven is at 1.66% so markets aren’t convinced. Very close to some sort of “Chuck Norris Effect” taking off and implementing this policy without any “concrete steps” imho. Good time to be long.

    Reply
  4. Matthias

     /  September 3, 2020

    I’m actually surprised markets reacted at all: the change in policy was long telegraphed.

    But I guess there was always the chance that the new policy would still be cancelled before it became official.

    Reply

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