Late-August saw the Federal Reserve (Fed) hold its keenly-watched annual Jackson Hole Economic Policy Symposium. Against a backdrop of the huge global uncertainty engendered by Covid-19, the focus on the conference was sharp.
Central banks have implemented further substantial policy measures to limit the damage from the Covid-19 lockdown and maintain financial stability. Nonetheless, at Jackson Hole the Federal Reserve yet again produced a big announcement.
Fed Chair Jay Powell unveiled a new policy “framework” amounting to Average Inflation Targeting (AIT), whereby it “seeks to achieve inflation that averages 2% over time”.
What is AIT?
This means the Fed will allow inflation (a measure of the rate at which prices rise) to run above 2% to make up for periods where inflation is below 2%. There was little detail on how this will be achieved, with Powell describing the approach as flexible rather than being tied to a mathematical formula.
This marks a slight change from the prevailing policy “orthodoxy” of the past 20-30 years. During this period, the key remit of central banks has been to achieve a fixed target level of inflation. If the level of inflation went above target the central bank would raise rates, to bring the rate of price increases back toward target, and vice versa. But essentially above target inflation would not be tolerated.
The idea of a fixed inflation target dates back a long way, but formally started to be adopted in the 1990s, New Zealand being the first to do so. The logic is that stable inflation is consistent with a well-functioning level of economic expansion. Its introduction in the 1990s came on the back of numerous shocks and often volatile conditions in the preceding decades.
The UK, as an example, adopted inflation targeting in 1992 following a painful currency devaluation. The Bank of England was given responsibility for setting interest rates in 1998 with an inflation target of 2.5%. The Fed, which for a long time worked to a target range of inflation, adopted a fixed 2% target in 2012.
How significant is the Fed’s move to average inflation targeting?
Since the 2007-2008 Global Financial Crisis, central banks have implemented unprecedented policies. Interest rates have been slashed, in some cases to near zero, and they have engaged in printing money in order to buy bonds and other assets, otherwise known as quantitative easing.
The global economy has seen some notable developments during this phase. US unemployment hovered at 50-year lows for two years prior to Covid-19. The US economy saw its longest ever period of growth. In one sense then, policy did its job of ensuring price stability, full employment and economic growth.
But, despite this expansion and low unemployment, amid loose policy measures, inflation has remained below target and the Federal Reserve has reduced its expectations for growth markedly. There are numerous reasons for persistently low inflation, but it seems fair to say that the current policy framework has reached its limit in respect of precipitating higher growth or inflation.
Powell’s speech acknowledged that stable prices are desirable for a well-functioning economy, but raised concerns of “an adverse cycle of ever-lower inflation and inflation expectations.” Japan’s “lost decade” of deflation (falling prices) from 1991-2001 is testament to this risk.
Financial markets give an indication of investor expectations of future inflation and these expectations have been low for some time. This seems logical enough. If the central bank says inflation will be targeted at 2%, why would it ever rise above that? On the other hand, it seems markets are now too wedded to the central bank’s target, and expectations have just been too low for too long.
The economist's view
Keith Wade, Schroders Chief Economist said “Although widely anticipated, the Fed’s move is significant. It’s an implicit acknowledgement that policy has been too tight and inflation too low for too long. This is an attempt to correct that.”
“Since the financial crisis low interest rates have not been as powerful as households have focused on reducing debt and lenders have been more cautious.”
Low interest rates could encourage governments to be more aggressive on the fiscal front (increasing public sending) which could create more demand and inflation, Wade explains.
“The change in Fed target may well push inflation expectations up, prompting workers to push for higher wages, which would potentially shift inflation too. At present though, the ability of workers to do this is low.”
How could this affect bond markets?
The initial market response has seen a “bear steepening” move in the US yield curve, where yields on longer maturity bonds rise more than yields on shorter maturity bonds. Maturity is the period of time after which the bond is repaid. For August, the yield on US Treasuries maturing in 30-years rose from 1.20% to 1.45% (bond prices move inversely of yields and interest rates).
This essentially indicates markets expect rates will be higher over the longer term as growth and inflation picks up, which is the intention of the Fed’s policy.
The bond fund manager's view
Lisa Hornby, US Fixed Income Portfolio Manager says, “The odds that long-dated yields continue to rise more than yields on short-dated bonds is quite high.”
"I see four key factors for this: 1) record Treasury issuance (that could be more skewed to the long end); 2) a demand gap where the new supply of bonds rises faster than the level of demand in the market; 3) the Fed’s new policy of inflation targeting (which means they won’t raise rates in anticipation of inflation but will wait until it happens); and 4) the Fed will only implement yield curve control (buying bonds in a targeted manner to keep yields low) as a last resort."
On the other hand, Wade said: “Upward pressure on long-dated yields will likely only persist if inflation really begins to pick-up. That might need more than loose monetary policy – help from other sources of stimulus like fiscal policy, through higher public spending, would also be needed”
“The difference will be further out as policy will now stay loose for longer as growth recovers and the economy is allowed to “run hot” for a period to try and generate higher inflation. Interest rates will stay lower for longer than under the previous framework.”
Hornby points out that the 10-year Treasury has averaged a yield of about 2.2% over the past 10 years, a return to this level would be a massive move from today’s level of about 0.75%. Investors positioned simply for lower rates and higher Treasury prices could be caught out.
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