Inflation update: Targeting a US inflation overshoot

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With the Federal Reserve (Fed) recently announcing the central bank would shift to a new policy framework of flexible average inflation targeting, Insight fixed income fund manager David Hooker asks: What are the implications for investors?

Shifting to a new policy framework:

On 21 August 2020, following an extensive review, Federal Reserve (Fed) Chairman Jerome Powell announced that the central bank would shift to a new policy framework¹: flexible average inflation targeting. This will see the Fed continue to target inflation at 2%, but over longer periods. In future, if inflation persistently fails to meet the 2% target, it will be allowed to run moderately above target such that inflation averages 2% over time. By making this change, the Federal Open Markets Committee hopes to anchor longer-term inflation expectations.

Another critical change was on employment, with the Committee now focusing on the extent of any shortfall in employment from its maximum level, and noting that the maximum level of employment is “not directly measurable and changes over time”. This implies that maximising employment and sustaining it at elevated levels will become a more important factor in future policy decisions.

Inflation has failed to materialise in the recent cycle:

Since the 2% inflation target was introduced by Ben Bernanke in 2012, inflation, as measured by the Personal Consumption Expenditure Price Index, has persistently failed to meet that target over time. A considerable gap has grown between the recorded level of prices and the level had inflation met the 2% target (see Figure 1). This has led to criticism that pre-emptive tightening of monetary policy to dampen perceived inflationary pressures (that have then failed to materialise in actual price rises) has simply damaged economic growth unnecessarily.

Figure 1: US inflation has consistently undershot target

Source: Insight and Bloomberg. Data as at 31 July 2020.

Implications for investors:

The clear message from this change in policy framework is that investors should expect monetary policy to remain at highly stimulative levels for an extended period. Even if inflation were to accelerate from current levels, the Fed would not just tolerate inflation above target – it is actively seeking it. Given the extent of the undershoot in recent years and the level of unemployment, it could be argued that the Fed would now accept quite an extended period of above-target inflation if it materialised.

The Fed’s assessment of the Phillips Curve² has also now radically changed, and it has noted that the maximum level of employment is a “broad-based and inclusive goal”. The benefits of high employment to income inequality now appear to outweigh any concerns that low levels of unemployment will generate wage inflation.

In the short-term there seems little reason to fear inflation, with abundant levels of excess capacity following the coronavirus crisis. But as we noted in our recent paper, many of the disinflationary forces that have held inflation at bay in recent years now appear to be drawing to a close. A future period of above-trend growth may have a very different inflationary outcome and be met by a central bank reluctant to take measures to deal with it.

¹https://www.federalreserve.gov/monetarypolicy/review-of-monetary-policy-strategy-tools-and-communications-statement-on-longer-run-goals-monetary-policy-strategy.htm
²A.W. Phillips created an economic theory known as the Phillips Curve, which stated that inflation and unemployment have a stable and inverse relationship. If unemployment declines, then the theory suggests that inflation should rise.

Important information:

https://www.bnymellonim.com/outlook/global-disclosure/

GE 96087, 3 DEC 2020

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