The Federal Reserve is yet again at the vanguard of innovative monetary policy. And as in previous cycles, we expect other major central banks to follow the Fed’s lead. In the last month, the Fed updated its monetary policy framework by formalising its flexible average inflation targeting policy. Under this new framework, two conditions would need to be met in order for the Committee to consider an adjustment to policy rates: one, inflation would need to run moderately above 2 per cent for a period of time to compensate for periods of low inflation; and two, longer-term inflation expectations would need to remain anchored at 2 per cent. This revised framework signals that policy interest rates remain at the zero bound for a long time into the economic recovery. 
At its latest meeting, the Fed explicitly reinforced the new policy framework by tying together short-term rates and inflation outcomes. In the Fed’s rate projection – as measured by the “dot plot” – no rate hikes were signalled at least until 2023. This renewed form of forward guidance and a strong commitment to wait until there is a “moderate” overshoot on inflation suggests that policy rates will remain at the zero bound long into the economic recovery and well past the achievement of full employment – in strong contrast to the last hiking cycle.
Inflation expectations in the US have responded well to the willingness of the Fed to remain stimulative. For example, US Treasury Inflation Protected Securities 10-year breakeven inflation has recovered from well below 1 per cent in Q1, to above 1.60 per cent today. The earlier sharp fall and subsequent rebound in inflation pricing seems, based on models and anecdotes, to have been driven largely by the disappearance and gradual return of liquidity, which has played out. From here though, to see further moves higher in long term inflation break-evens, the onus is on higher inflation outcomes and maintenance of extraordinary monetary and fiscal stimulus.
There is considerable uncertainty on whether the Fed will achieve higher inflation outcomes. There are also a number of open questions on how the Fed will act to generate such inflation or, in fact, whether the Fed alone has the power to do so. Thus far the Fed has refrained from applying pre-programmed rules for makeup strategies nor stated a level of inflation overshoot they are willing to withstand. Or, for that matter, how long they would be willing to wait before reacting to higher inflation. This flexibility affords the Fed leeway to adapt to changing economic conditions but equally makes it hard for investors to position for this change in framework.
How does this change from the Fed affect the inflation outlook? Very little in the near term. Inflation is likely to remain under downward pressure while the US and the global economy deals with large output gaps and high levels of unemployment coming out of this Covid-19 crisis. Large amounts of economic slack and secular forces that weigh down on inflation (like technology and low wage bargaining power) are key reasons why the next few years may yet again be characterised by low inflation and hence a low interest rate environment.
The medium-term outlook, though, is more mixed and there are now building risks of higher medium-term inflation outcomes in the US and other major developed economies. This new era for central bank policymaking where the majority of the emphasis is on remaining ultra-accommodative until inflation is high and rising is a monumental experiment. At the same time, the appetite and willingness for governments to spend to shore up economies in this crisis is vastly higher than at any other time in the post-financial crisis era. Strong coordination between monetary and fiscal policy in this new cycle is a necessary condition to ignite inflationary pressure. But it remains to be seen whether this coordinated policy will be sufficient in isolation.
The Federal Open Market Committee’s reflation experiment creates some headaches from the perspective of portfolio diversification. Recent equity market gyrations are a warning of an upcoming period of higher volatility given significant uncertainty around political events, as well as the appropriate valuations for growth stocks. At the same time, by effectively pinning down Treasury yields, monetary policy has impaired one of the usual channels for insulating portfolios. The challenge of effective portfolio hedges implies the appetite to take large risk positions – typical of an early cycle – should be moderated in multi-asset portfolios. Equally multi-asset investors are increasingly seeking out protection and diversification in high-quality segments of the credit markets which benefit from implicit and explicit guarantees from major central banks.
Thushka Maharaj is global multi-asset strategist at JP Morgan Asset Management. The views expressed above are her own and should not be taken as investment advice.