The Federal Reserve’s Federal Open Market Committee, (FOMC) today adopted a policy of average-inflation targeting by which it will aim to achieve inflation above its long-term 2% goal for a while to offset the erosion of inflation expectations caused by years of undershooting that goal. This policy move was expected, although its formal adoption in the Statement on Longer-Run Goals and Monetary Policy Strategy in conjunction of with Chairman Powell’s Jackson Hole speech and in advance of the September FOMC meeting was a surprise.
In the statement and the speech, the Fed put special emphasis in achieving a maximum level of employment as “a broad-based and inclusive goal,” suggesting that it was willing to allow the unemployment rate to fall to very low levels in an attempt to help those who have the most difficulty in finding employment, within the bounds of its price and financial stability goals.
The Fed did not, at this time, specify by how long or how much inflation would be allowed to exceed 2% in order to make up for previous shortfalls, an omission that will give it further flexibility in the implementation of policy.
In addition, the FOMC statement reasserted that “The Committee’s primary means of adjusting the stance of monetary policy is through changes in the target range for the federal funds rate”.
If this were, in fact, the case, markets would have little reason to react to the new policy one way or another. After all, for many years, the Federal Reserve, like other major central banks, has consistently failed to raise inflation to a 2% target through the use of very low short-term interest rates.
However, in reality, the primary means of adjusting the stance of monetary policy in 2020 has been through massive balance sheet expansion as the Fed has added over $2 trillion to its holdings of U.S. Treasuries so far and is continuing to grow its Treasury holdings at a pace of $20 billion per week. This has effectively allowed the federal government to implement a massively stimulative fiscal policy. This policy has supported household incomes during the pandemic and is contributing to a faster economic rebound. If this policy is continued as the economy recovers further in 2021 and beyond, the U.S. inflation rate could well move above the Fed’s 2% target, just as is envisioned in the new policy.
Because of this markets have reacted quite logically to today’s Fed news, with both stocks and long-term rates rising. Moreover, long-term interest rates could rise further still in the months ahead as investors recognize that the Fed’s goal of pushing inflation of above 2% for a while, is quite easy to achieve with the help of the fiscal elephant in the room.
David Kelly is chief global strategist at J.P. Morgan Asset Management.