On August 27 at the Federal Reserve’s annual Economic Policy Symposium, Chairman Jerome Powell announced a significant change in Fed policy that comes on the heels of a year-long internal policy review. This policy change is seismic in scope, and it will greatly affect how the central bank will manage inflation moving forward. While on the surface the policy shift to an “average inflation” target may seem minor, it could have far-reaching implications within the fixed income markets.
Prior to this shift, the Fed had historically relied on inflation models and adjusted monetary policy based on these forecasts to achieve their 2% inflation target. This strategy effectively ignored prior inflation rates when setting future policy. The new Fed policy means those prior inflation rates are now an important part of future monetary policy. Moving forward, the Fed will target an average inflation rate of 2% over time, letting inflation exceed the target for potentially long periods to make up for periods when inflation fell short of the 2% target. The Fed noted that the reason behind the policy change was recent evidence showing that the relationship between the unemployment rate and inflation has shifted. Unlike previous decades, the last 10-15 years have demonstrated that lower levels of unemployment have not led to higher inflation.
The shift to average inflation targeting is obviously much broader and a more subjective policy than prior Fed policy. With this shift, market participants need to evolve their thinking on the fixed income markets, as it is much less clear how the Fed will react in response to new economic data. Based on this new approach, it is likely we will see the following occur:
• Lower federal funds rates for longer time periods and steeper Treasury yield curves. When the economy begins to recover from the COVID-19-induced recession, the Fed is now much less likely to raise interest rates right away. Most likely, the Fed will let inflation run above its 2% target for an extended period of time. Also, as the economy improves (assuming that the Fed does not raise rates), it is highly likely we will see a steeper yield curve, as investors may demand a larger premium for holding long-term bonds due to the new uncertainty around potential Fed action.
• Higher inflation uncertainty. With the Fed’s shift to a significantly more subjective policy, there will of course be more uncertainty about future inflation. This uncertainty will most likely lead investors to demand a greater inflation premium to hold traditional nominal bonds.
While the full effects of this policy change may not be known for many years, your team at Lumia Wealth will continue to monitor and evaluate the effects and make appropriate changes to our clients’ portfolios.