Despite changing its policy framework with the introduction of an average inflation target (AIT) and aim of maximum employment, the US Federal Reserve (Fed) took no action at its latest policy meeting.
Interest rates and asset purchases remain unchanged, although the central bank did give a steer on how its new policy would work going forward.
A change in approach
The Fed refreshed its Summary of Economic Projections, which forecasts how growth, interest rates, inflation and unemployment will develop in the years to come. Its inflation forecast was notable, as it showed inflation moving back up to 2% in 2023.
That this came alongside no change in projected interest rates marks a departure from the past. Previously, the Fed would have signalled a tightening of policy in response to such an outlook.
Under the previous regime, inflation rising to 2% would be met by a pre-emptive tightening to cool the economy and keep inflation stable. The need to act ahead of a potential inflation overshoot above 2% reflected the lags between policy action and its impact on the real economy. The new policy means that the Fed is willing to wait until inflation has gone above 2% until it responds.
Monetary policy still acts with lags, but the change in policy reflects the experience of the past decade, where efforts to be pre-emptive have led inflation to consistently undershoot its 2% target. As a result, policy can be said to have been too tight. For example, the Fed’s preferred measure of inflation has only hit 2% for brief periods in the past decade and the 10-year rolling average has been below 2% since 2002 (chart 1).
Chart 1: Missing in action: actual and target inflation
Source: Schroders, Refinitiv Datastream, 14 September 2020
This persistent undershoot has attracted criticism of the Fed for raising interest rates too quickly, with adverse consequences for growth and employment.
Although we do not as yet know the time period over which the Fed intends to hit an average inflation target (AIT) under its new framework, an average of the last four economic cycles (as measured by the National Bureau of Economic Research) comes in at just under ten years.
On this basis the current 10 year inflation average of 1.6% implies a significant period of inflation above 2% to hit the AIT. Clearly, all things being equal, monetary policy will have to be looser than if the Fed were aiming to bring inflation back to 2%.
Will the Fed be able to generate higher inflation?
Whilst changing the target is one thing, actually hitting it is another. In the near term the Fed’s options are limited as monetary policy is already very loose. Fed chair Powell has ruled out using negative interest rates, so any tweaks would be to forward guidance or asset purchases (QE). But essentially we are close to maximum stimulus.
The difference will be further out as policy will now stay loose for longer as growth recovers and the economy is allowed to “run hot” for a period to try and generate higher inflation. Interest rates will stay lower and QE continue for longer than under the previous framework.
This may create higher inflation, but as we saw before Covid-19 struck, even with unemployment at 50-year lows it has been difficult to generate 2% inflation. Low unemployment no longer sparks increases in wages or price inflation and, as has been widely observed, the Philips curve – which measures the relationship between these factors - has flattened.
Two challenges to hitting the new target
There has been a significant amount of research and analysis on this topic, but we would highlight two factors which are consistently important and would need to change if the Fed is to meet its new target:
First, there has been a reduction in worker bargaining power. Many attribute this to globalisation, which effectively increased the pool of labour competing for work and has contributed to the decline in trade union bargaining power as firms have off-shored labour. Labour market de-regulation measures such as flexible contracts and zero hours have also contributed.
Second, the stickiness of inflation expectations means that workers do not push for higher wages even at low levels of unemployment. This has been a particular feature in Japan, but also elsewhere. In effect central banks have been victims of their own success in convincing people that inflation will not be allowed to accelerate in the future. Expectations tend to be very adaptive or backward-looking, so inflation has to be created first for workers to start noticing and demanding higher compensation. Policy announcements alone are not sufficient.
This presents the Fed with a chicken and egg problem. It has been made worse by the fact that the Fed is embarking on its new policy at a time of massive deflationary pressure following the collapse in activity. Although growth is now rising with the easing of lockdowns, the downdraft from the recession in the first half of this year will be felt well into 2021 (chart 2). Inflation could fall to the levels seen in the last recession and consequently expectations and wage demands are likely to be depressed.
Chart 2: Drop in activity points to sharp fall in inflation
Source: Schroders, Refinitiv Datastream, 14 September 2020
With monetary policy largely exhausted and inflation set to fall further in the near term, the odds seem to be stacked against the Fed meeting its new target. However, looking beyond the short term there are trends developing which point toward greater inflation in the future.
Inflationary trends at play
The Fed’s policy tools have clearly lost much of their power since the global financial crisis as households have de-leveraged and banks have become more heavily regulated. However, fiscal policy should still be effective. Whilst this is the remit of government rather than central banks, the latter can encourage the former to be more aggressive on the fiscal front through keeping bond yields along the curve low and allowing a higher sustainable level of government borrowing. This has already been achieved through forward guidance and QE, it could be ultimately supplemented by yield curve control where the Fed simply sets the yield on the 10 year bond, as seen today in Japan.
Looser fiscal policy could then create excess demand and inflation. This theme could become even more significant should governments move toward policies advocated by the Modern Monetary Theory (MMT) school of economics, where expenditure is directly funded through money printing. However, this would require a regime change and would be in the long term rather than near or even medium term horizon in our view.
Another potential inflationary trend is the recognition that inequality is a problem in the economy. The change to the Fed’s mandate is an example of this, with a greater focus on maximum employment. This reflects a rebalancing of the aims of policy away from inflation and toward spreading the gains from growth to the lower income section of the population. Fed chair Powell noted these benefits when the labour market was tight through stronger wage growth at the lower end of the wage spectrum. This is the case for running the economy “hot”.
How the US presidential election might impact inflation
Furthermore, both candidates in the forthcoming presidential election have policies which could reverse the weakening of worker bargaining power. President Trump continues to rail against China and we are seeing a gradual roll-back of globalisation through his policies to check US engagement. Global trade has weakened and the president is now aiming to restrict US corporate investment in China. These policies will eventually create a more regionalised and less competitive environment, which in turn would be more inflationary.
Meanwhile, although Joe Biden may be less overtly aggressive toward China, he is still likely to continue in the direction taken by his predecessor on trade and investment. He is also set to directly address inequality by doubling the minimum wage to $15 an hour to help boost the incomes of lower paid workers. His more pro-union stance is another factor which could swing bargaining power back toward workers.
Of course, there are factors such as technology which can still act as a deflationary force in the US and world economy, but it is clear that the tide is beginning to turn on the area of inequality and wage bargaining.
More easing in near term?
The Fed chose not to move yesterday and it has its work cut out in meeting the new AIT, especially in the near term as the downdraft from the recession will weigh on inflation. This may mean we see more easing by the Fed in the coming months and the possible introduction of yield curve control at least for a period.
Further out though, the increased focus on inequality and running the economy hot will combine with loose fiscal policy and stronger worker bargaining power to bring the target into view.
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