THE FED FINE-TUNES ITS MANDATE
On August 27th, Fed Chairman, Jerome Powell, gave a speech specifying a change in the Fed’s monetary policy framework. After a two-year policy review, the Fed has adopted a new framework, formalizing a shift in thinking that will likely change market anticipation of Fed actions. Specifically, the new framework assumes a slower economy will persist for the indefinite future. This condition will result in lower inflationary pressures, which makes their previous policy framework outdated and ineffective. In addition, the definition of employment was changed significantly. Since the rate of employment is a proxy for economic growth, this also has implications for how the Fed implements monetary policy.
The dual Fed mandate of maximum employment and price stability set by the US Congress in 1977 remains unchanged. But how the Fed defines “maximum employment” and “price stability” have changed. Since Alan Greenspan was the Chairman (1987-2006), the Fed has pursued a policy of gradualism tied to the Taylor Rule. The Taylor Rule says Fed Funds should be a function of the deviation of inflation from a target and deviation of economic growth from its target. Typically, the Fed has substituted the unemployment rate for economic growth, with the idea that once the unemployment rate deviates from its target, long thought to be 4.5%, inflationary pressures would build. Importantly, this target is based upon headline inflation and does not take into account underlying demographics. But from the Global Financial Crisis of 2008 until the Pandemic of 2020, the global developed market economy has been characterized by historically low unemployment, persistently low inflation and sub-par economic growth. This has led to the realization that the Taylor Rule doesn’t work under current conditions. There has also been recognition that while the headline unemployment number has been low, not all groups have shared equally in the benefits of strong job growth.
So what are the potential changes to monetary policy? Operationally, it’s likely a move away from the gradualist monetary policy of Alan Greenspan. The Fed for some time has had a 2% target rate of inflation, but now it is an average of 2%, meaning inflation can be above (or below) 2% for some time. Since 2% is no longer a fixed target, the Fed no longer needs to start raising rates as soon as inflation starts rising. This change is a realization that the economy will not grow as fast as previously assumed and so the build-up in inflationary pressures will be slower.
In policy terms, they will not raise interest rates until inflation comes close to its long-run target of 2%, and will allow inflation to go above 2% under certain circumstances. How long inflation may be higher than 2% or by how much is not specified since “. . . we are not tying ourselves to a particular mathematical formula that defines the average.” Price stability is now defined as varying around a target rather than staying at a target.
The definition of “maximum employment” has changed significantly, but its nuances have not been discussed much in the media. They will be guided by “shortfalls” from the maximum rate of employment rather than “deviations,” a clear break with the Taylor Rule. This change “reflects our view that a robust job market can be sustained without causing an outbreak of inflation.” Powell also states “that specifying a numerical goal for employment is unwise . . .” in continuity with the policy statement of 2012. But included is the idea “that maximum employment is a broad-based and inclusive goal.” This implies that the headline employment number will no longer have their sole attention. The Fed will also consider demographics within the total employment picture when setting monetary policy, another clear break with the past. In his speech, Powell spent a good bit of time discussing the employment situation for different groups and how the benefits of low unemployment were not shared equally since the GFC, so this is clearly an important part of their thinking.
Finally, while it appears that the Fed is changing position, they may be formalizing what they have been doing for some time. “To an extent, these revisions reflect the way we have been conducting policy in recent years.”
So forecasting or anticipating Fed policy just became harder. Rather than raising rates at the first whiff of inflation or drop in the unemployment rate, the Fed is likely to let things ride, including above-target unemployment or inflation. In addition unemployment within a certain demographic will be considered alongside the headline number. But there is much ambiguity about the calculation of the average rate of inflation and how the different demographic groups will be weighted in determining the current level of employment. None of this changes the current market state, but it will have implications for asset allocation and fixed income investment in the coming years.
Reference (for all quotes)
Powell, J. H. “New Economic Challenges and the Fed’s Monetary Policy Review”, Remarks at an economic policy symposium at Jackson Hole, Wyoming, August 27, 2020.
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