“Patience" May Be Replaced by “Flexible" as the Fed Debates Inflation

Fed Chair Powell gave his semi-annual testimony to Congress last week to present an assessment of the current state of the U.S. economy.

To summarize his views, economic growth remains steady, the labor market remains strong and inflation is well contained. However, downside risks are visible, particularly those from what is becoming a pronounced slowdown in overseas economies, which has the potential to dent growth here at home. As such, the FOMC is committed to patience before raising the Fed Funds Rate in 2019 after hiking rates four times last year.

The word “patience” has become the most popular way to describe the Fed this year, but we would argue “flexible” may take the top spot moving forward. This is because Powell, along with a host of other committee members in recent weeks, has begun to highlight the months-long review of its policy framework, which appears to be centered around the current inflation target of 2%. The formal inflation target of 2% was introduced in 2012, but inflation has generally remained below that since the financial crisis.

Inflation ex. Food and Energy (Core)

With inflation having lagged below target, the Fed is debating whether to become more flexible in how it assesses setting the Fed Funds Rate. Currently, the Fed targets 2% inflation each year, without regard to what has occurred in the past. One alternative would be to react to what happened previously by taking historical inflation into account when setting policy rates. For example, if inflation was below 2% last year, the FOMC could let inflation rise above 2% this year without raising rates. Another potential approach would be to target an average level of inflation at 2% over the course of the business cycle. As Powell put it, “think of ways of making that inflation 2% target highly credible, so that inflation averages around 2%, rather than only averaging 2% in good times and then averaging way less than that in bad times.”

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In either approach, the flexibility around the current level of inflation and policy rates will be key. In a flexible environment, the Fed would avoid raising the Fed Funds Rate if inflation breaks above 2%. Longer-term bond yields would likely rise in this situation as higher inflation eats into the real value of future interest payments. Despite all this talk, the bond market has remained quite steady this year, which means investors aren’t concerned with inflation moving higher or this new approach being implemented, or a combination of the two.

Source: Bloomberg, NatWest Markets, WSJ