Taken together, the recent combination of testimony, press releases, and other communications suggest that the US Federal Reserve (Fed) may be considering a shift to average inflation targeting. If true, this could mean the Fed would move away from trying to engineer a sustained, specific inflation level and would be free to allow above-target inflation for a period before using rate hikes to slow the economy. Such a shift could certainly change how the Fed reacts to new economic and market data. Although there are still many questions around this possible new framework, Invesco Fixed Income believes it would have positive implications for US and global macro performance and could benefit risk assets.
Average inflation targeting could reduce Fed dependence on forward-looking data
Average inflation targeting means the Fed would prefer that inflation average 2% over a given business cycle (with the ability to fluctuate above and below 2%) rather than imposing an informal cap near its 2% target.1
How might this change the way that the Fed operates?
Historically, the Fed has generally relied on a forward-looking view of inflation, meaning it has based policy decisions on economic models and forecasts. For example, the unemployment rate has traditionally been a leading indicator of inflation. If models suggested inflation would accelerate beyond its target in the future, the Fed would hike interest rates in anticipation. This methodology drove the tightening cycles in 2004 through 2007 and 2016 through 2017. In both cases, core personal consumption expenditures (PCE) inflation either just overshot or never consistently met the Fed’s 2% target, but since inflation was expected to accelerate based on forward-looking data, rates were hiked anyway.
Moving toward average inflation targeting implies that the Fed would not tighten monetary policy as much based purely on forward-looking data, unless inflation was already above-target.
Why might the Fed change its approach?
The previous policy framework has resulted in an extended period of inflation below the Fed’s 2% target. On a year-over-year basis, core PCE inflation has been above-target in only six months since the start of the global financial crisis.2 And since the Fed achieved inflation near its 2% target for the first time in the 1990s, core consumer price inflation has spent only 24% of the time above-target.3 Over this period, consumer inflation expectations have drifted to low levels (Figure 1), and if these expectations continue to drift downward, it may become increasingly difficult to achieve the 2% inflation target in the future.
Figure 1: Consumer inflation expectations have declined
Source: University of Michigan, data from April 1990 to April 2019. The University of Michigan Inflation Expectations survey of consumers presents the median expected price changes for the next five to 10 years. Past performance is no guarantee of future results.
In the current business cycle, the US has yet to obtain 2% inflation on a sustainable basis. Core PCE inflation reached 2%4 in July 2018 but has since retreated to 1.8%5 and will likely continue to decrease, in our view. If the economy slows before inflation picks up, we may not see sustainable 2% inflation before the next recession.
The Fed may change the way it reacts to incoming information
A focus on average inflation could cause the Fed to react differently to incoming market and economic information. For example, the Fed noted elevated lending to the corporate sector and possibly high asset valuations in its November review of financial conditions. Previously, this scenario might have led the Fed to change monetary policy in response to overly loose financial conditions. However, with an increased focus on achieving average inflation around its target, the Fed may focus less on such data.
This policy shift may also facilitate swifter reactions to global shocks. There have been two major global financial shocks in the past decade — the European debt crisis in 2012 and a Chinese growth slowdown in 2015. In both cases, US core PCE inflation dropped even though economic measures of slack were stable. As such, the Fed delayed taking any monetary policy action since the threat to US growth was unclear. However, if the Fed believes that global slowdowns will drag down US inflation (as in the recent past), they may consider adjusting policy more quickly.
A policy shift could support risk assets
This shift by the Fed would likely lead Invesco Fixed Income to adopt a more positive view on our macro factors: growth, inflation and financial conditions. Achieving average inflation would likely prevent the Fed from preemptively raising rates and could result in a longer business cycle. Inflation could also trend higher than it does under traditional policy. We believe these positive changes would benefit credit assets and eventually lead to a higher, steeper yield curve. This environment would also suggest a weaker US dollar, but in our view, we see the direction of the dollar as largely dependent on the economic performance of other countries.
We expect greater clarity in 2020
By leaving interest rates on hold in the first quarter of this year and lowering guidance for 2019 overall, the Fed has already taken policy actions consistent with achieving average inflation. However, this type of policy may or may not be adopted on a permanent basis. The Fed may still revert to its old ways of reacting if financial conditions ease too quickly or the unemployment rate starts to decline again. The Fed is currently conducting a review of how best to achieve its dual mandate of price stability and full employment. Policymakers plan to make their findings public in the first half of 2020. If the Fed decides to permanently emphasize average inflation, the change may be announced at that time.
1 Source: US Federal Reserve, target set in Jan. 2012.
2 Source: Bureau of Economic Analysis, data from Oct. 31, 2008 to Jan. 31, 2019.
3 Source: Bureau of Economic Analysis, data from Dec. 31, 1994 to Jan. 31, 2019.
4 Source: US Bureau of Labor Statistics, data from Aug. 10, 2018.
5 Source: US Bureau of Labor Statistics, data from April 10, 2019.
Blog header image: Good Vibrations Images/Stocksy.com
The core personal consumption expenditures (PCE) price index measures the price changes of consumer goods and services, excluding food and energy prices. It is reported by the US Department of Commerce’s Bureau of Economic Analysis.