Almost two years after the Federal Reserve announced a long-running public review of its monetary policy framework—but still earlier than most Fed-watchers expected—its chair, Jerome Powell, used his Jackson Hole speech to reveal a significant change in its approach.
The speech was light on detail, so expectation is building as we head into the September Federal Open Market Committee meeting tomorrow. The announcement solidifies market expectations for potentially many more years of zero rates. But we think the Fed may need to deliver something more to reinforce the messaging behind the new framework.
Death of the ‘Taylor Rule’
Right now, what we know is that the Fed used to aim for an inflation rate of 2%, but now it will aim for a 2% rate on average over an as-yet-unspecified period of time.
In addition, the central bank will now seek to avoid shortfalls from maximum employment rather than responding to small deviations from the perceived non-accelerating inflationary rate of unemployment (NAIRU), given that the NAIRU is now apparently too low to be of practical use. It will also aim for maximum employment that is “broad-based and inclusive”—an entirely new social aspect to its policy. We believe that this asymmetric jobs objective reflects the fact that sections of the U.S. workforce that tend to be hired last always miss out if conditions are tightened before maximum employment is achieved.
The new policy framework marks the death of the “Taylor Rule” and its variants, which posited a stable coefficient between inflation and the central bank rate.
Even more decisively, it ends the era of preemptive tightening. Under that regime, the Fed would use economic growth as a leading indicator of inflation and hike early to avoid overshooting the 2% target. By contrast, the new approach is backward-looking and designed to overshoot.
Let’s say that the Fed aims for a 2% average over the course of a business cycle. History suggests we will likely be in recession 20% of the time, with Personal Consumption Expenditures (PCE) rising by 0.5% a year. To get a cycle average of 2%, we would therefore need to sustain PCE at 2.4% for 80% of the time, during expansions. That implies a 2.6 – 2.9% inflation rate for the Consumer Price Index.
Persuading consumers and financial markets that this is achievable seems difficult. We think additional action is required to reinforce the change in approach.
That could include taking the dot-plot forecasts for 2023 all the way to zero regardless of the unemployment rate. Outcome-based forward guidance is an option, perhaps linked to a three- or five-year window of realized inflation. The Fed could edge toward yield-curve control by sharing its long-term long-dated rate views in its quarterly Summary of Economic Projections.
So far, however, most Fed speakers have linked attainment of the new target with changes in the size, speed or term structure of open-ended quantitative easing.
Currently the Fed buys $80 billion of Treasuries per month, split across the term structure according to the amount of debt outstanding. As such, only a third of QE purchases are dated beyond five years. Focusing QE beyond five years would likely flatten the curve, reduce the term premium and ease financial conditions for companies and mortgage borrowers. Buying more Treasury Inflation Protected Securities, currently only 9% of QE purchases, could also assist in normalizing inflation expectations more quickly.
It seems likely to us that something along these lines will emerge from this week’s FOMC meeting.
A Mighty Big ‘If’
If successful, the new approach would eventually steepen the yield curve and potentially push breakeven inflation up to 2.00 – 2.5%. Interest-rate volatility would likely rise as markets attempt to price for the subsequent tightening that would follow the return to higher inflation. And macroeconomic volatility would also pick up as growth and inflation rise.
But that is a mighty big “if.”
Skepticism is widespread. Average core PCE over the past expansion was just 1.6% even before it crashed below 1% this year. It only climbed above 2% for a matter of weeks, during the early part of the expansion in 2011 and following the Trump administration’s tax cuts in 2018. The cumulative policy errors of the past have left us with a four- to five-percentage-point inflation gap, and inflation would need to run at 3% for four or five years to close it.
It’s possible that the new approach will fail to raise inflation and instead merely further inflate the “TINA” bubble in equities, which could threaten financial stability. On the other hand, it might work too well: Inflation can be nonlinear and difficult to contain when concern about it becomes lodged in consumer psychology.
Furthermore, we should remember that monetary policy needs to respond to unforeseen events as well as the leisurely undulations of the economic cycle. It’s striking that, under the new framework, the Fed would never have hiked from the zero rate implemented in December 2008—but COVID-19 would still have happened in 2020.
In other words, this is a meaningful change—and the outcome is uncertain and the risks are high.
In Case You Missed It
- Japan 2Q 2020 GDP (Final): -7.9% quarter-over-quarter (-28.1% annualized)
- Eurozone 2Q 2020 GDP (Final): -11.8% quarter-over-quarter
- China Consumer Price Index: 2.4% year-over-year in August
- U.S. Initial Jobless Claims: +884,000 for the week ending September 5
- U.S. Producer Price Index: +0.3% in August month-over-month and -0.2% year-over-year
- European Central Bank Policy Meeting: The Governing Council made no changes to its policy stance
- U.S. Consumer Price Index: +0.4% in August month-over-month and +1.3% year-over-year (core CPI increased 0.4% month-over-month and 1.7% year-over-year)
What to Watch For
- Wednesday, September 16:
- U.S. Retail Sales
- NAHB Housing Market Index
- Federal Open Market Committee Meeting
- Bank of Japan Policy Meeting
- Thursday, September 17:
- U.S. Housing Starts and Building Permits
- Eurozone Consumer Price Index
- Japan Consumer Price Index
Statistics on the Current State of the Market – as of September 11, 2020
|S&P 500 Index||-3.3%||-4.5%||4.8%|
|Russell 1000 Index||-3.4%||-4.8%||5.1%|
|Russell 1000 Growth Index||-4.9%||-7.3%||20.9%|
|Russell 1000 Value Index||-1.6%||-1.9%||-11.1%|
|Russell 2000 Index||-3.0%||-4.1%||-9.4%|
|MSCI World Index||-2.4%||-3.5%||2.0%|
|MSCI EAFE Index||-0.1%||-0.6%||-4.9%|
|MSCI Emerging Markets Index||-1.5%||-0.8%||-0.2%|
|STOXX Europe 600||0.5%||-0.6%||-5.0%|
|FTSE 100 Index||3.1%||1.2%||-18.0%|
|CSI 300 Index||-3.9%||-3.9%||15.2%|
|Fixed Income & Currency|
|Citigroup 2-Year Treasury Index||0.0%||0.0%||3.0%|
|Citigroup 10-Year Treasury Index||-0.4%||0.3%||12.6%|
|Bloomberg Barclays Municipal Bond Index||0.0%||0.0%||3.3%|
|Bloomberg Barclays US Aggregate Bond Index||-0.3%||0.2%||7.0%|
|Bloomberg Barclays Global Aggregate Index||-0.3%||-0.2%||5.9%|
|S&P/LSTA U.S. Leveraged Loan 100 Index||0.5%||1.0%||0.5%|
|ICE BofAML U.S. High Yield Index||-0.6%||-0.4%||0.4%|
|ICE BofAML Global High Yield Index||-0.5%||-0.4%||1.5%|
|JP Morgan EMBI Global Diversified Index||-0.9%||0.5%||1.8%|
|JP Morgan GBI-EM Global Diversified Index||-0.1%||0.1%||-4.3%|
|U.S. Dollar per British Pounds||-3.7%||-4.5%||-3.5%|
|U.S. Dollar per Euro||-0.1%||-1.1%||5.4%|
|U.S. Dollar per Japanese Yen||0.0%||-0.1%||2.3%|
|Real & Alternative Assets|
|Alerian MLP Index||-5.0%||-7.6%||-42.4%|
|FTSE EPRA/NAREIT North America Index||-2.8%||-1.7%||-19.1%|
|FTSE EPRA/NAREIT Global Index||-2.3%||-1.7%||-18.4%|
|Bloomberg Commodity Index||-1.0%||-2.4%||-11.2%|
|Gold (NYM $/ozt) Continuous Future||0.5%||-1.6%||27.9%|
|Crude Oil WTI (NYM $/bbl) Continuous Future||-9.8%||-12.4%||-38.9%|
Source: FactSet, Neuberger Berman.