Dollars and Sense

The Federal Reserve is constantly evolving its approach on monetary policy, and the Jackson Hole conference in August offered another proof point. After nearly two years of waiting for the results of its strategic review, Fed Chair Powell unveiled high-level particulars of a new approach. Going forward, the Fed will no longer be prescriptive in targeting a specific unemployment rate and will implement Flexible Average Inflation Targeting (FAIT). The combination is intended to enable the Fed to more effectively meet its mandate of full employment and stable prices. For market participants, the key takeaway was that the policy rate will remain lower for even longer relative to the Fed’s prior approach. 

Don’t let history get in the way of full employment

Let’s start by looking at the employment side of the new framework. Going forward, Fed members will adjust monetary policy based on “assessments of the shortfalls of employment from its maximum level”. Previously, the Fed focused on “deviations from its maximum level.” This is a very nuanced change that we will unpack. Typically, the Fed would say that full employment is reached when the unemployment rate is close to 4% -- it’s estimated NAIRU. According to the Fed’s economic model, inflation would then stabilize at 2%. Importantly, that full employment level is determined by historical observations and, as we saw in the past business cycle, does not always work. Back in February 2020, the unemployment rate was 3.5% and inflation was still running below 2%. The Fed has now deemed that adjusting monetary policy based on a threshold as ineffective. 

The new policy framework allows the Fed to formalize a review of employment conditions in a more inclusive way. Although it had always taken a broad view of the labor market, this policy approach offers significantly more room for interpretation and flexibility. For instance, back in February, there was plenty of data that would not have inferred that the economy was at full employment. Wage growth was rising, but remained well below what was implied by a 3.5% unemployment rate. The number of people underemployed or working part-time for economic reasons also implied the labor market was not fully utilized. Going forward, financial markets shouldn’t automatically anticipate tighter monetary policy action upon viewing an unemployment rate trending below historical levels should the Fed communicate that further inroads can be made.

Putting Inflation to the Fire

The shift in the Federal Reserve’s inflation targeting approach was timely considering that the U.S. economy is currently operating well below capacity. The Congressional Budget Office (CBO) estimates that the economy is running at only 90% of its potential and that it will take nearly a decade to close that gap. What does this mean for inflation? Well, disinflationary forces dominate, particularly if the economy hits another bump in the road during that period. To demonstrate, we apply the CBO’s output gap and inflation expectations as the principle drivers within an econometric model (Chart 1). In doing so, the Federal Reserve’s preferred inflation metric (core PCE) is set to remain below the 2% target for the foreseeable future. To avoid this outcome, the Fed needs to reset market expectations. FAIT is hoped to do just that.

How FAIT is Different

Prior to the new framework change, the Fed would use the historic economic relationship between employment and inflation (the Phillips Curve) to gauge whether the latter was on track to hit 2% over the next 12 to 18 months. This strategy has some pitfalls. In December 2015, the Federal Reserve raised its policy rate for the first time since the Global Financial Crisis (GFC), believing that the economy was on track to meet its mandate. At the time, the unemployment rate was at a seven year low of 5.0% and core PCE inflation was running at 1.20% year-on-year. However, it took until early-2018 for inflation to reach 2% and it didn’t stay there long. In early 2019, inflation dropped below that mark again and has never recovered. All told, inflation has averaged just 1.6% since 2009, having spent over 90% of that time below the Fed’s 2% target. 

With a flexible AIT approach, the Fed is saying that it wants inflation to average 2% over time, rather than simply meet that threshold at a point in time. Periods when inflation undershoots the target will be offset by periods where it is permitted to overshoot. In effect, play catch-up. With price pressures currently running at only 1.25%, it has already been undershooting the target for 19 straight months. The catch-up period offers quite a bit of runway before the Federal Reserve would need to respond with higher interest rates or quicken the pace of a tightening cycle.

In Chart 2, we show what the future path of ‘inflation catch-up’ could look like. Using the FOMC forecast for core PCE from now until 2022, the members see inflation getting to 1.5% at the end of 2021 and 1.7% by the end of 2022. After that, if core PCE inflation continues to rise in a linear fashion to 2.5%, Chart 2 shows that the 2% average inflation target for the current cycle will be reached in the year 2029 – or, roughly 5 years later than the Fed’s original inflation targeting approach. Though we do not know over what period the average of inflation will be calculated (hence the reference to ‘flexible’), the change will allow the economy and the job market to ‘heat up’ in a sense, elongating the time it takes for the Fed to reach its target.

If it takes longer for the Fed to reach its objective, it will also take longer for the Fed to raise its policy rate. In Chart 3, we show the path of the fed funds rate using a FAIT framework and compare it to the time-variant framework and the original Taylor Rule. This shows that instead of raising rates in late-2022/early-2023, the Fed would remain on the sidelines until 2024. The one-to-two year delay in raising rates is substantial! This feeds through to yields via lower expectations for future policy rates. 

Market pricing for the path of the Fed can’t get much lower. Currently, market participants aren’t expecting much in terms of rate hikes over the next 10 years. With expectations anchored at a time when the Fed is shaking up inflation expectations, there has been an increase in the term premium risk for long-term Treasuries. This is because it’s not yet clear how much of an inflation overshoot the Fed is willing to accept. Will it be 2.5% (from our scenario above) or 3.5%? And for how long? There needs to be further detail on the strategy framework to avoid market misalignment and a rise in yields like what happened during the Taper Tantrum of 2013.

To give a little more context on how the new framework will impact Fed policy decisions, we did a little ‘what if’ analysis. Here we apply the new framework on past cycles and see how FAIT would have influenced monetary policy outcomes (Chart 4, Average inflation is over the business cycle). Prior to the busting of the Dot Com Bubble, the new framework would have urged the Fed to raise rates faster and to a higher level than what other monetary policy rules would dictate. In the run-up to the Global Financial Crisis and the current pandemic-induced recession, the new framework would have encouraged the Fed to exert more patience.

The Bank of Canada’s Review

The Federal Reserve isn’t alone in reviewing how it conducts monetary policy. The Bank of Canada (BoC) has been conducting a similar exercise since 2018 and will release the results in 2021. Governor Tiff Macklem’s remarks at Jackson Hole indicated the Bank’s framework is headed in a similar direction. His comments complemented recent remarks by Senior Deputy Governor Carolyn Wilkins, who spoke about how the BoC is “running a horse race among alternative frameworks for monetary policy (which) include average inflation targeting, price-level targeting, an employment-inflation dual mandate and nominal GDP growth and level targeting.” Also on the table is a raising of the BoC’s inflation target.

The Bank of Canada currently operates with a 2% inflation target but has a 1% to 3% operating band around it. This already gives the Bank flexiblity with its inflation control framework. Even with this flexibility, core inflation in Canada has mirrored that of the U.S. (Chart 5). With past inflation misses in Canada, a greater openness to compensate for undershooting has been welcomed by markets. If the BoC does not follow the Fed towards greater flexibility, a relatively tighter policy stance could become counterproductive to maintaining inflation and economic stability. 

We suspect that road won’t be crossed and the BoC will evolve its policy mandate. In fact, the BoC has a strong track record in adapting to new research, realities and perspectives. The Bank of Canada is disciplined in reviewing its inflation-control mandate every five years. In doing so, the 2016 review marked a change in practices where it departed from the convention of most other central banks, shifting its focus from a single core inflation measure (CPIX) to instead follow a diversified approach of three measures (CPI-common, - trim, -median) in a nod to the strengths and weaknesses of each. And, prior to that policy tweak, it had departed from using an even more simplified CPI core metric (excludes food and energy) in favor of the CPIX. Evolution is fundamental to achieving economic and financial stability. The economy and its structure are not static over time, nor should there be an expectation of the same from policy leaders.  

Bottom Line

The Federal Reserve’s change to Flexible Average Inflation Targeting is an effort to fight the stubbornly low inflation that has persisted for the last decade. It is trying to reset inflation expectations. A longer road ahead in meeting inflation and employment objectives, equates to a more patient central bank and a policy rate that will be anchored lower for (even) longer. 

The Fed may have beaten other central banks to the punch, but the Bank of Canada will likely evolve its approach. It may choose not to follow the same direct objective of FAIT, but the end result of lower for longer will be the likely outcome.