Updated 4:32pm ET August 7, 2020
Framing a new policy framework possibility
Will inflation ever get back to the Federal Reserve's 2.0% longer-run target on a sustained basis? The Federal Reserve sure hopes so, and if a recent press report has it right, the Federal Reserve may soon condone a policy that tolerates the inflation rate running above 2.0% without taking any policy-tightening action.
Earlier this week, CNBC.com ran an article that suggested the Federal Reserve might announce a change to its policy-setting framework, shifting to an "average inflation" target. This change, it was said, could be announced before, or at, the September FOMC meeting.
Since inflation has been running below the 2.0% target for some time, the implication is that the Fed would be comfortable allowing inflation to run above 2.0% to achieve an average inflation rate of 2.0%.
According to the article, the Fed would likely signal to the market that it isn't going to raise the fed funds rate until it has met its inflation and employment targets. Considering the current unemployment rate of 10.2% is still above the peak rate seen during the Great Recession, it's going to take a whole lot of hiring activity and probably a good bit of time before the employment target is hit.
The Fed knows this, and Fed Chair Powell even suggested as much at his July press conference. The connection for market participants is that they needn't worry about the Fed being quick to stamp out inflation pressures with interest rate hikes.
A Policy Paradox in the Making
As a matter of policy, an inflation rate above the 2.0% longer-run target would be welcome in the Fed's mind because it would help the Fed meet its long-run target on an average basis. This might be the new policy framework, but it's also quite the policy paradox relative to a dual mandate of price stability and maximum employment.
The Fed would essentially be conceding price stability in the near to intermediate term to achieve its inflation target.
The working assumption is that holding rates steady near the zero bound would facilitate stronger growth, which in turn would drive increased hiring activity to the point of maximum employment. Stronger economic growth would presumably lead to higher inflation, which is what the Fed desires at this juncture.
In other words, "Voila!"
Keep rates at the zero bound, see growth rebound, see hiring activity pick up, see inflation rise without any issue, and live happily ever after.
On Planting Ground
Average inflation targeting might be the new framework, but it's doubtful that a pretty picture is going to fit neatly in that frame.
When rates are held at the zero bound for an extended period, capital will get misallocated and, most likely in the case of the stock market, over-allocated. It's the planting ground for asset bubbles, which the Federal Reserve doesn't have the best track record managing. It's the planting ground for devaluing the savings for a large swath of the adult population that lacks the disposable income to invest in the stock market. It's the planting ground for raising the cost of living (assuming the Fed gets its inflation wish) for everyone and certainly an aging baby-boomer generation that will be increasingly reliant on a fixed income. It's the planting ground for dollar debasement. It's the planting ground for fostering moral hazard.
There's so much more to the story, too, that won't make for a neat growth picture. The COVID experience is doing some major structural damage that won't be undone easily, even with a vaccine. The cost of containment and recovery has been enormous, and the payback period won't be short or conducive to growth if massive budget gaps are going to get filled and debts repaid. Services will get cut and taxes will increase.
Prices may even increase, too, but at what cost? There are a lot of structural issues to contend with, including low birth rates and the rising cost of entitlement programs, which were a fiscal problem in the making even before COVID.
What It All Means
The Fed may announce a new policy framework that prescribes an average inflation target. We think Fed Chair Powell hinted at this when he acknowledged at his latest policy press conference that the COVID experience is fundamentally a driver of disinflation and that the economy is apt to be dealing with disinflation pressures, as opposed to inflation pressures, for some time.
That's not what the Fed wants knowing it has missed its 2.0% longer-run inflation target for the better part of the past ten years.
The Fed wants more inflation than it has been getting and its leader sees COVID as a fundamentally disinflationary event. Accordingly, it is not unreasonable to think the Fed is going to embrace a new framework that will effectively leave it tinkering outside the price stability box.
That might get the stock market excited to think the Fed is going to keep its policy rate unchanged near the zero bound for some time (years perhaps) and encourage the persistence of negative real interest rates, but the policy-driven picture down the road is unlikely to be as pretty as the Fed thinks it will be in its design stage.
The Fed may get inflation. The stimulus pump from both a monetary and fiscal perspective is primed like never before. The growth component, however, isn't assured given the structural issues in front of us.
If the Fed embraces a policy that incorporates an average inflation target and a willingness to keep rates low as the inflation rate rises above 2.0%, it will also be raising the risk of stagflation, which is a picture nobody wants to see in any framework.
--Patrick J. O'Hare, Briefing.com
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