Fed is shifting the goal posts, and investors should care
The way the inflation target is implemented could change, with big implications for markets
Two words in Federal Reserve Chairman Jerome Powell’s opening comments on Wednesday mattered: “transient” and “symmetric.”
The markets focused only on the first, with stocks and gold falling and bond yields rising as Mr. Powell described this year’s drop in inflation as transitory, implying less chance of interest-rate cuts. The second might matter more in the long run, as the Fed embarks on its first review of its 2% inflation target set seven years ago. Mr. Powell and Vice Chairman Richard Clarida have already made clear that the target itself isn’t up for debate but the way it is implemented could change, with big implications for markets.
This is where “symmetric” comes into play. In itself, it just says that inflation above 2% is as acceptable as inflation below 2%, but it has gained symbolic importance because of the Fed review. June last year was the last time the word featured in Mr. Powell’s statement at the start of the regular press conference, and he went on to say that he expected discussions at some point about targeting average inflation—so a period of below-target inflation would be followed by the Fed letting the economy run hot. That is true symmetry and is now being discussed as an option by Fed policy makers.
Goldman Sachs thinks the emphasis on symmetry in the inflation target is already influencing long-dated bonds, as investors anticipate modestly higher inflation over the long run. JPMorgan strategists think the market is already anticipating a “regime shift” to target average inflation, multiplying the impact of the Fed’s dovish turn in January.
If there is a change by the Fed, the effects could be significant in pushing up the prospects for long-run inflation and so bond yields, with knock-on effects across markets. It could also begin a shift by central banks around the world away from the simple inflation targets that have come to dominate policy over the past three decades and open the door to more radical changes, including an acceptance of higher inflation.
Central bankers who support the idea of an average inflation goal hope to solve the problem that interest rates are likely to hit the zero lower bound again in the next recession, leaving the Fed with little ammunition to fight deflation.
There is also a short-term benefit in bolstering inflation expectations, which have fallen back since October.
The bond market’s implied consumer-price inflation for the five years starting in five years’ time suggests a loss of faith in the Fed’s ability to hit its goal.
Because bonds are linked to consumer prices while the Fed uses the personal-consumption-expenditures prices, bond markets would need to price in roughly 2.5% to be consistent with the Fed being on target. Instead, bonds are priced for just 2.05% inflation.
Aiming for average inflation would help in a recession because, assuming investors believed the Fed, they would expect rates to stay lower for longer, as the Fed wouldn’t need to clamp down on inflation so quickly in the eventual recovery. That should hold down long-run bond yields and so keep monetary policy easier than it otherwise would be, aiding the economy.
Compare that to 2008. The Fed had to use forward guidance and buy bonds directly in its quantitative-easing program in order to convince investors that rates would stay low for a long time. An average inflation goal should do something similar automatically.
Aiming for an average of past inflation has drawbacks, however.
David Wessel, director of the Hutchins Center on Fiscal and Monetary Policy at the Brookings Institution and a contributing correspondent to The Wall Street Journal, points out that it might be seen as unfair by a young adult told she has to pay more for a car loan because the Fed is trying to keep inflation low to compensate for overshooting when she was still a child.
Worse, such a policy could stop the Fed from taking action to slow an unsustainable boom that follows a period of slow price rises, because it is still making up for undershooting in the past.
Broadly speaking, the Fed’s rates would be lower at the peak of a boom than under the current policy, which could make financial markets even more prone to bubbles.
Some academics prefer an average of forecast inflation, which solves these problems. It has a problem, too, though: the Fed, like other central banks, hates to predict inflation above its target. Most Fed policy makers predict inflation will be exactly 2% in 2021, with a maximum prediction of 2.2%. No one likes to miss their goals, but to predict high inflation would be to invite political questions about why nothing is being done to prevent it.
Whatever is done is likely to have more impact on financialmarket thinking than it does on the real economy. Boston Fed President Eric Rosengren and colleagues warned in a paper last year that the impacts of even radical change are likely to be quite small. Even a doubling of the inflation target to 4%— which isn’t on the table—would only allow rate cuts to offset 1 percentage point more of unemployment. A shift of regime would help in the next downturn, but be far too little to allow the Fed to deal effectively with a repeat of the 2007-09 recession.
Billionaire hedge-fund manager Ray Dalio is one of those who thinks the answer to central banks running out of ammunition is for the Fed to finance government spending and tax cuts in a recession. European Central Bank President Mario Draghi frequently calls for more spending by fiscally conservative Northern European governments to boost the region’s struggling economy. If monetary policy proves impotent in the next recession, central-bank-financed spending may well enter the political mainstream.