The Federal Reserve’s Inflation Shift

Written by: Tim Benzel

It isn’t often that the Federal Reserve updates its thinking around the dual mandate of promoting maximum employment and price stability, which it was formally tasked with by Congress in the late 70’s. In fact, the last update was made in 2012, when then Fed Chair Bernanke quantified what price stability meant by formally establishing a 2% inflation target.

Since that time, reaching the 2% inflation mark has proved quite difficult, which is why the Fed recently embarked on a study of whether that goal should be revised. Last week, during the Fed’s annual Jackson Hole economic symposium, held virtually, current Fed Chair Powell announced the conclusion of that study, which detailed a small but important shift. Instead of having 2% inflation be a hard target, which may cause the Fed’s Open Markets Committee (FOMC) to tighten monetary policy, it will use 2% as an average target, meaning that the Fed will seek periods of above 2% inflation if inflation runs below 2% following economic downturns.

The revamp is designed to address the “reality of a quite difficult macroeconomic context of low interest rates, low inflation, relatively low productivity, slow growth and those kinds of things,” said Fed Chairman Jerome Powell. “We’ve really got to work to find every scrap of leverage in helping stabilize the economy.”

What this means in practicality is that investors should not expect the Fed to raise the Fed Funds Rate anytime soon, even if the economy and employment rebound sharply from the current Covid-19 induced shock. Had this policy been in place after exiting the financial crisis, the Fed likely would have kept the Fed Funds Rate at the zero bound throughout the last decade, instead of raising it periodically from 2015 through 2018.

Of course, the Fed only controls the Fed Funds Rate, which typically sets yields on the very shortest of bonds. Longer-term interest rates are set by the market, with inflation being a key component. So, while this change in thinking by the Fed is historic, it may not be enough in and of itself to drive inflation higher. That will be left to the economy and variables such as money supply growth and velocity, technological innovations, etc.. As of this writing, we are not seeing signs of inflation meaningfully picking-up but will continue to pay close attention as the market impacts from inflation could be significant, even if the Fed’s reaction isn’t.

Related: Taxable Municipal Issuance on Record Setting Pace

Source: Federal Reserve, Wall Street Journal as of August 27th, 2020.