Wall Street is still weighing the implications of the Fed’s most substantial shift in its monetary policy thinking in years.
In essence, Federal Reserve Chairman Jerome Powell on Thursday stressed the primacy of the labor market in its mission, even if it means that inflation rose to 2% above the annual target, and the central bank traditionally believes that the target indicates a healthy, well-functioning economy.
Powell’s new policy framework comes after an 18-month review by the Federal Open Market Committee, which sets interest rates, and marks a subtle shift from targeting 2 percent inflation to now allowing for downward and over-adjustment of inflation, which will average 2 percent over time.
“The change may seem subtle, but it reflects our view that a strong job market can be sustained without leading to a burst of inflation,” Powell said in his webcast address Thursday as part of the annual Jackson Hole Symposium.
Indeed, the shift is a big deal experts say, not just because of the decades-old central bank orthodoxy defending the relationship between labor markets and price pressures, but also because it expresses a policy that may be far removed from that advocated by Stanford University economist John Taylor, who has championed a mathematical approach to setting interest rates.
The Fed’s new approach may instead raise more questions than answers about implementation, with the key being how to achieve the inflation target that has been elusive for the past decade.
“How much inflation is the Fed happy with?” Aneta Markowska, chief economist at Jefferies, asked in a research note on Friday.
“The FOMC is surprisingly vague about its inflation averaging framework, saying only that it will work toward achieving inflation ‘moderately above 2 percent over time’ after a period of insufficient inflation. What does this mean in practice? We simply don’t know.” The economist wrote.
In the wake of Powell’s Jackson Hole speech, some Fed officials did try to provide some sense of the extent to which inflation might be allowed to rise above the central bank’s target before sounding the alarm.
“To me, it’s not a number, whether it’s 2.5 percent or 3 percent,” Philadelphia Fed President Patrick Harker, a voting member of the FOMC, told CNBC in an interview Friday.“It’s whether it gets to 2 percent, climbs to 2.5 percent, or shoots through 2.5 percent,” he said.
St. Louis Fed President James Bullard (James Bullard) is not a voting member of the FOMC, he said last Friday, the inflation rate may be maintained at 2.5 percent for a “considerable period of time”.
Inflation plays a key role in Fed policy because too low a rate of inflation can lead to overall economic weakness by encouraging consumers, the main drivers of the U.S. economy, to postpone purchases and by amplifying expectations of lower prices, promoting a potentially vicious cycle. As the Fed has said, “If inflation expectations fall, interest rates will fall as well.”
And the receding interest rates have made it difficult for the Fed to use its main tool for managing monetary policy: the federal funds rate. The Fed lowers the benchmark rate to stimulate economic activity and raises it to slow it.
It’s worth noting that he Fed has raised interest rates nine times between 2015 and 2018.
However, price pressures have been nowhere to be found since at least 2009, with a break-even point of 1.6% based on 5-year, 5-year forward inflation. This measure of inflation calculates the expected pace of price increases over the 5 years from now.
Experts say the lack of clarity around the specifics of its change in policy could inject more uncertainty into the market in the long term.
“Much is left unsaid when it comes to how the committee views the shift in its inflation target, and careful consideration suggests that the new approach may actually complicate the policy process in terms of implementation and communication,” Robert Eisenbeis, chief monetary economist at Cumberland Advisors, said in a note Friday.
Eisenbeis said the Fed did not immediately specify which measure of inflation it would use. Traditionally, the central bank’s preferred measure of inflation has been the PCE price index, or personal consumption expenditures price index, but Wall Street typically refers to the CPI, or consumer price index.
“Finally, the elephant in the room is that the [Federal Reserve] has been pursuing a 2% inflation target since January 25, 2012, but has consistently fallen below that level,” wrote analysts at The Cumberland.
“The Fed now needs to really explore this new regime change at the FOMC meeting, because telling us their plan is great, but how they enact it is what the market really needs to know,” wrote Chris Weston, a research analyst at brokerage Pepperstone.
Lara Rhame, chief U.S. economist at FS Investments, said the impact of the Fed’s move may not play out until after this covide-19 crisis is over.
“The real question for investors will be what happens after this economic crisis,” The Economist wrote.
“Many are hopeful that the economy will continue to recover over the next year or two. If a vaccine or a more effective treatment helps curb the epidemic, that could happen much faster,” said FS Investments analysts.
“But [Thursday’s] announcement has made it clear that even a return to steady potential growth means the Fed is likely to leave interest rates where they are – at zero,” the economist said.
The Fed’s upcoming policy meeting on Sept. 15-16 may fill in some blanks for market participants.
The impact on the market
So what does this mean for the financial markets?
That implies a regime that could lower interest rates, but market expectations of volatility could increase without more guidance on how Federal Reserve policy will work.
In the short term, the stock market may continue to rise, or at least tend to hold steady, as the Fed makes it clearer that it has no intention of raising interest rates anytime soon.
“One of the few things that could knock the market down is the possibility that the Fed could start raising rates…. I don’t know if this [policy shift] will lead to a further meltdown, but I’m sure it does put the market on a safer footing,” Brad McMillan, chief investment officer at Commonwealth Financial Network, told MarketWatch.
On Friday, the Dow Jones Industrial Average
All closed at records.
“It’s hard to bet against the stock market right now,” said David Donabedian, chief investment officer at CIBC Private Wealth Management, in emailed comments.
Commonwealth’s McMillan also said that growth stocks, which have performed compellingly in a short-term low interest rate regime, may continue to benefit.” Future cash flows will be more valuable in the present for those companies that can generate them,” he noted.
“Those companies with pricing power, such as commodity stocks, will benefit. Banks will eventually enjoy a steepening of the yield curve. For companies that don’t have pricing power and thus have to endure upward pressure on costs, margins will be squeezed, and that won’t be a good thing,” wrote Peter Boockvar, chief investment officer at Bleakley Advisory Group, in a note Friday.
“Cheap stocks, the so-called value side, have inherently built in low expectations, so they will be more immune. Interesting times,” he said.
Analysts at BofA Global Research, including Michelle Meyer, said they don’t expect a broad-based rise in the dollar.
After Powell’s speech.
Analysts wrote in Thursday’s report that “without another bout of risk aversion, the broad rally in the U.S. dollar may finally be contained, as dollar shorts have been concentrated among a typically less price-sensitive group of asset managers.”
The theory is that lower interest rates and higher inflation will provide support for bullion prices, which have already attracted significant safe-haven capital as investors worry about the economic impact of the coronary virus on global business activity.
To a lesser extent, it is seen as a hedge against uncertainty and rising inflation. A weaker, or at least stable, dollar has also helped support the price of precious metals.