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Fed Weighs Monetary Policy Implementation Changes

By Richard "Crit" Thomas, CFA, CAIA
Economy & Markets
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When the Fed raises or lowers interest rates, they don’t really know the full economic impact for at least a year. Such a long lag makes the job of setting monetary policy very difficult.

The experience of the runaway inflation in the 1960s and 1970s left an indelible mark on how the Fed conducts monetary policy. Namely they adopted a proactive approach. It’s not about where inflation is today; it’s about where inflation is likely to be a year from now. As such, the Fed would somewhat blindly raise rates with the expectation of tamping down a fire that is expected to start a year away. This approach exposed the Fed to both timing and magnitude risks. Lately, we are seeing signs that the Fed is beginning to reconsider this approach which could have a meaningful impact for our economy and the markets in the future.

Unemployment & Inflation: Fit to be Untied?

While the Fed considers many factors in their decision making, the unemployment rate has been one of the most prominent. Historically, there has been an inverse relationship between the unemployment rate and subsequent inflation (an economic concept developed by A.W. Phillips and referred to as the Phillips curve). Typically, a very low rate of unemployment has been seen as a trigger for inflationary pressures. Yet during this economic cycle that relationship hasn’t held; the unemployment rate continues to fall but inflation remains range bound. In July 2019 testimony to the Senate Banking Committee, Fed Chairman Jerome Powell stated that the tie between unemployment and inflation “has become weaker, and weaker, and weaker.”

Unemployment Versus Inflation since February 2010

Source: Bloomberg

Inflation: The Problem or the Solution?

In fact, the Fed, under Powell, has begun to reconsider their concern about inflation. Runaway inflation fears are being replaced by fears of too little inflation. In a 2019 speech, Powell stated that “low inflation seems to be the problem of this era, not high inflation.” More recently, San Francisco Fed President Mary Daly stated:
We need to embrace the mindset that inflation a bit above target is far better than inflation a bit below target in today’s economic environment.
This is very different language coming out of the Fed.

Daly went on to state that despite low unemployment, wage gains have remained modest, “few models would have predicted this. Little history would have told us this was possible.” She added that “our traditional approach” to monetary policy is no longer effective in today’s market environment.

So, exactly how do you conduct policy if your models don’t work and history is no longer a guide?

This has been the topic of a yearlong series of “Fed Listens” events to get input from academics, policy makers, business leaders and others on different approaches to achieving their policy objectives and how to communicate them. While my eyes want to roll at the idea of a Fed listening tour, it appears that it may be more influential than originally expected.

Reframing the Target

About a year ago, the Fed introduced the word “symmetric” in describing how they are targeting inflation. The intended message was that they would be okay with inflation running slightly ahead of their goal. More recently the Fed has discussed a more dramatic approach called Average Inflation Targeting (AIT). AIT differs from the current symmetrical goal of 2% inflation in that they would take into account inflation levels in the past (looking in the rearview mirror). Powell stated that with AIT “there would be some aspect of trying to make inflation average 2% over time, which means if it runs below 2% for a time it has to run above” for some time. In fact, if the look back is over the last five years, inflation would need to run at a 2.5% rate for the next five years to average out to percent.

You may think, who cares, they can’t even reach their 2% target. As investors, I think we should care. A lot. While the Fed may not have singularly caused every recession going back to the 1950s, they certainly had a hand in every one of them. If the Fed becomes less anticipatory in their policy decisions, they are much less likely to make a preemptive mistake and put us in a recession. In 2019, the Fed partially re-opened the liquidity damn and then told us it is likely to remain open for the foreseeable future. While many question whether this will result in higher inflation, it certainly appears to be resulting in higher asset prices.

Can’t Stop Thinking About Tomorrow

I do believe the markets are correct to see these apparent changes at the Fed as very positive. There is nothing better than an accommodative Fed; even better a toothless one. But, I do need to raise one potential risk. A risk that is not currently priced in the marketplace. What if the Fed succeeds? Many believe that we have not seen wages or inflation rise simply because we have not reached full employment. As long as we keep producing more jobs than the growth rate of the labor force (estimated to be 80,000-100,000 monthly), the labor market will get tighter. Imagine if inflation starts running slightly above the 2% target and the Fed stands idly by. I would expect longer-term bonds would sell off along with stocks with high P/E multiples. In this scenario, cyclical stocks would be poised to take over leadership.

At the start of this year, we did recommend dipping a toe into more cyclical exposure and reducing bond duration. We noted that Central banks around the world have been very accommodative and with the signing of the phase one trade deal we expected a global upturn. There had been confirming signs of an upturn, but the outbreak of Coronavirus has arrested the rise. We do think investors should look through this viral event as we believe it will prove transitory, though admittedly the near-term economic damage looks to be larger than originally thought.

This summer, the Fed will more formally address the listening tour and how it may impact monetary policy going forward. Meanwhile, the risk of the Fed raising rates has meaningfully receded into the distance.

This commentary is for informational purposes only and should not be used or construed as an offer to sell, a solicitation of an offer to buy, or a recommendation to buy, sell or hold any security. There is no guarantee that the information is complete or timely. Past performance is no guarantee of future results. Investing in an index is not possible. Investing involves risk, including the possible loss of principal and fluctuation of value. Please visit touchstoneinvestments.com for performance information current to the most recent month-end.

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crit thomas global market strategist

Richard "Crit" Thomas, CFA, CAIA

Global Market Strategist
Crit is responsible for examining and evaluating economic conditions, generating insights and providing a sharpened perspective on investment strategies for enriched portfolio construction.

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