The Fed has made big changes to its mission: here’s why that matters

The US Federal Reserve is changing the way it targets inflation. And that’s a lot more important than it might sound. John Stepek explains why.

Last week, Federal Reserve chairman Jerome Powell made a speech at the (virtual) annual Jackson Hole central bank shindig.

In it, he announced a couple of changes to the way the Fed does things.

That sounds like an arcane matter for academics of finance and economics.

It’s not. It’s really important.

Here’s why.

What’s changed about the Fed’s policies?

The Federal Reserve, the US central bank, has historically targeted an inflation rate of 2%. The idea was that if inflation went above or below this level for any length of time, the Fed would get worried and have to act. (Whether you believe such action helps or hinders matters is irrelevant – it’s about the Fed feeling it has to “do something”.)

Now though, the Fed says it will target inflation “that averages 2% over time”. Why does that matter?

Because the addition of that little word “averages” provides a great deal more flexibility for the Fed. In the past decade or so, inflation has been drifting around below the 2% target more often than it has been above it.

So on average, the Fed has been missing the 2% target (depending on the timescale you choose). That means that in theory, under the new regime, the Fed could see inflation rise above 2% and sit there for quite some time, and still meet its “average” 2% target. It would have no reason to act to attempt to halt the rise.

Indeed, the fact that 2% is now the “average” target implies that the Fed should be doing its very best to push inflation higher from here. As the Fed policy itself puts it: “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”

In other words, from here on in, you can view the Fed’s target as being closer to 3% than 2%.

Even more important was the emphasis on employment. Unlike the Bank of England, the Fed is explicitly told to look at employment as well as inflation (of course, all central banks consider employment – it’s a core aspect of the economy and thus of inflation management).

What’s changed is that the Fed is now putting employment ahead of inflation in its priorities list.

What the Fed’s shift of focus means for investors

The obvious question for investors is: why does this matter? We knew the Fed was gunning for higher inflation, even before the coronavirus recession. Powell’s predecessor, Janet Yellen, talked about “asymmetric” inflation targeting for much of her term. There’s no big revelation here.

And of course, there’s the simple fact that for all the Fed might want inflation to rise sharply, it’s not clear that triggering inflation is within the Fed’s gift. After all, it hasn’t managed it so far.

Those are fair and reasonable points. But it would be a mistake to imagine that this is irrelevant.

Firstly, there’s a big difference between having a “nudge, nudge, wink, wink” average inflation target and making it official. The former gives the market the message that the Fed will let inflation go up and won’t be too hasty to tackle it, so investors shouldn’t fear that rates will rise too.

The latter is a big advance on that. It suggests that not only will the Fed not be too hasty to raise rates, it might have to cut them further or print more money if there’s no sign of inflation rising above 2%. The shift not only gives the Fed cover for loosening monetary policy from here - it positively encourages it.

That may or may not push inflation higher, although my own view is that a sufficiently determined central bank in combination with an equally determined government can push inflation up if it wants to.

But even if you’re an inflation sceptic, recent history suggests that if nothing else, looser monetary policy will push asset prices higher and contribute (somewhat ironically) to the vulnerability of the financial system.

Secondly, the shift in focus to employment makes all of this much more explicit. The reality is that as long as unemployment is high, the Fed doesn’t really care about inflation.

We’ve got the latest non-farm payrolls release on Friday, which will give an idea of the state of the US labour market. But whether it’s better or worse than expected, one thing will be clear – unemployment will remain unacceptably high for some time to come.

This suggests that interest rate rises are so far off into the future that most investors can assume near-0% rates forever.

That’s one reason why the Nasdaq – the most obvious manifestation of the “long duration” or “jam tomorrow” bubble – keeps roaring higher.

What can throw a spanner in the works? The only thing I can think of is inflation. Proper inflation. The sort that the Fed can’t ignore. But that’s a while off, and it’ll likely require governments to go for broke. That looks as though it’s coming, but we probably have to get the US election out of the way first. Although a stronger-than-expected economic recovery could also help.

What does it mean for your money? In the shorter term, this has been negative for the US dollar. It’s also a supportive backdrop for precious metals, although given their stellar recent run, the reaction has been reasonably muted so far.

In the longer term – well, it’s just another step on the road we’ve been outlining for a while. So you can stick to your plan. And if you don’t have one, now’s a good time to get one.

It’s also a good time to subscribe to MoneyWeek magazine – get your first six issues free here.

Recommended

Inflation is the easiest way out of this – just don’t expect politicians to admit it
Inflation

Inflation is the easiest way out of this – just don’t expect politicians to admit it

The UK government borrowed £34.1bn in December, a record amount for that month. Britain's debt pile now amounts to 100% of GDP. How are we going to pa…
22 Jan 2021
Beware: inflation is starting to stir in the US
Inflation

Beware: inflation is starting to stir in the US

With US consumer prices up by 1.4% in the last year, concern about inflation is now everywhere.
22 Jan 2021
When lockdown ends, be prepared for an inflationary surprise
UK Economy

When lockdown ends, be prepared for an inflationary surprise

The government is pouring more money into the economy to tide businesses over the latest lockdown. Once lockdown ends, says John Stepek,we should see …
5 Jan 2021
It’s time investors prepared for inflation
Inflation

It’s time investors prepared for inflation

A lot of people seem to think that big price rises are a thing of the past. But investors could be hit with a few inflationary surprises in the coming…
18 Dec 2020

Most Popular

Why we won’t see a house-price crash in 2021
House prices

Why we won’t see a house-price crash in 2021

Lockdown sent house prices berserk as cooped up home-workers fled for bigger properties in the country. And while they won’t rise quite as much this y…
18 Jan 2021
Inflation is the easiest way out of this – just don’t expect politicians to admit it
Inflation

Inflation is the easiest way out of this – just don’t expect politicians to admit it

The UK government borrowed £34.1bn in December, a record amount for that month. Britain's debt pile now amounts to 100% of GDP. How are we going to pa…
22 Jan 2021
The best investment trusts to buy for 2021
Investment trusts

The best investment trusts to buy for 2021

Sectors ranging from emerging markets to student accommodation look poised to do well this year, says David Stevenson, as he picks the best investment…
19 Jan 2021