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What the Fed’s new inflation stance means for future rate moves and investors

September 2020

The U.S. Federal Reserve is signalling a new approach to how it will balance its two objectives of maintaining stable prices and maximum employment, indicating it may be slower on the trigger to ultimately raise interest rates when the U.S. economy improves.


Fed Chair Jay Powell unveiled the changes at this year’s Jackson Hole symposium, held virtually in Wyoming this year.


Under the new strategy, the Fed will take a more flexible approach to how it targets inflation. In the past, the central bank has geared monetary policy around keeping price gains at 2%, but will now “seek to achieve inflation that averages 2% over time.” This change signals if inflation runs below 2% for an extended period, the Fed will now aim for that to be followed by a period of inflation “moderately” above 2% for some time.


As the Fed has in the past responded to extended periods of above-2-percent inflation by raising interest rates, this indicates a significantly dovish long-term shift for the central bank, says Gluskin Sheff’s Head of Asset Allocation, Matthew Lehmann.

Essentially they will wait until inflation overshoots to hike, he says

The Fed will also change how it views employment levels in relation to inflation and interest rates. Maintaining strong employment levels alongside stable inflation has always been a bit of a tightrope for the Fed, as times of very low unemployment can lead to wage inflation that can drive broader inflation higher.


But future policy moves will be based on assessments of the ‘shortfalls’ of employment from its perceived maximum level, rather than its previous language of ‘deviations’ from its maximum level. In other words, the Fed will be more comfortable with unemployment reaching extremely low levels, without seeing that as a harbinger of inflation that it will need to act on.


“This change represents a shift toward an asymmetric response to the employment gap under which an unemployment rate below the estimated natural rate of unemployment is not a sufficient reason on its own to tighten policy,” says Lehmann.


The Fed is making these changes due to insights gathered from the central bank’s first-ever comprehensive review of its monetary policy framework, which it launched last year after noting “changes in the economic environment”. Its key insight was the neutral level of the federal funds rate – the level where the rate keeps the economy steady when inflation and employment are close to the Fed’s objectives — had fallen in recent years.


All of this is in the context of the low interest rate environment that has been by and large in place since the 2008 financial crisis, but has not triggered runaway inflation as many economists had once predicted it would.


Indeed, in a nod to its evolving perspective on the relationship between inflation and economic performance, the Fed says that going forward it will consider its policy and long run goals annually.


What the Fed’s move means for investors


The Fed’s announcement had little immediate impact on asset prices, save for a small steeping of the yield curve as bond investors reacted to the dovish tone and concluded that rate hikes are not in the foreseeable future.


But as the economy gathers strength, possibly in a post-COVID-19 world, the new policy stance will start to show itself in the Fed’s actions.


On the surface, the policy shift seems like it should be good for stocks, as extended low rates mean a continuation of cheap borrowing for investors and businesses, as well as continued low yields for bonds at the short end of the curve.


A possible implication over the medium term could be a shift in the term risk premium of U.S. Treasuries, or the difference in yields between short and long-term bonds that accounts for the risk of inflation and other economic factors over a longer time frame.


That premium has been at historically low levels in recent years, as inflation has seemed unlikely to be a factor in the foreseeable future, says George Young, Chief Risk Officer at Gluskin Sheff + Associates.


“If the market finds the Fed’s new framework credible, there is a chance that markets adjust their inflation uncertainty distribution, and it becomes skewed back to the high side,” he says.

This would cause the (U.S. Treasury yield) curve to steepen, which would have major implications across asset classes.

This could also make interest rates in general more volatile, which could affect business and personal borrowing, and create more volatility in other assets.


Part of the Fed’s thinking in this shift undoubtedly stems from the central bank’s desire for higher inflation than we’ve seen in the last several years. With interest rates already at rock bottom levels, the Fed has little room to cut them more, meaning it would have limited tools to deal with a situation where price growth drops to a near-deflationary situation, or one where a weak economy needs the traditional turbocharge it gets from an interest rate cut.


In its statement, the Fed specifically mentioned the federal funds rate – it’s chief mechanism for adjusting its monetary policy stance – is “likely to be constrained by its effective lower bound more frequently than in the past”, meaning the Fed is worried about running out of room should it need to make a move. Having an additional inflationary cushion could alleviate some of that concern.


That said, Young notes that just because the Fed has signalled it is more comfortable with higher inflation doesn’t mean they’ll be any more successful in achieving it, and current indicators certainly don’t point to it.


Thus, he expects little meaningful market reaction until the economy is able to generate inflation on its own, meaning investors will likely have to continue to take higher risks to find yield.


“Announcing your fire department has a new policy for fires doesn’t matter if there aren’t any. But when there is a fire, now the new policy matters,” he says. “In the meantime, rates are going nowhere in the front end for a long time.”

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