Yesterday was “interesting,” to say the least. The Fed surprised markets with another unscheduled policy update and bonds traded accordingly. The surprise in question was an exceedingly well understood shift in the Fed’s inflation framework. And I’m not just speaking generally. Here are a few newswires from the past year in which various Fed speakers lay out exactly what was ultimately announced yesterday:
- JUNE 5, 2019 – CHICAGO FED’S EVANS SAYS NEED TO DEFEND 2% SYMMETRIC INFLATION TARGET ‘VERY STRONGLY’- BBG
- OCT 2, 2019 – FED’S WILLIAMS SAYS FED SEES 2% INFLATION GOAL AS A SYMMETRIC GOAL; LOOKING AHEAD THE GOAL IS TO HIT GOAL MOST OF THE TIME
- OCT 3, 2019 – FED’S CLARIDA SAYS IT’S IMPORTANT INFLATION BE ACHIEVED ON A SYMMETRIC BASIS AROUND 2% LEVEL
- OCT 11, 2019 – KASHKARI SAYS INFLATION SLIGHTLY ABOVE 2% SHOULD NOT LEAD TO HIGHER INTEREST RATES GIVEN SYMMETRIC INFLATION TARGET
- DEC 11, 2019 – POWELL SAYS THE FED IS STRONGLY COMMITTED TO ACHIEVING SYMMETRIC INFLATION GOAL
There was no doubt markets understood the Fed to be indicating a willingness to let inflation run hotter than the traditional 2% in order to offset the periods of time where it ran below 2%. The net effect is “symmetry” around a 2% mid-point, hence the term “symmetric inflation target.”
All of the talk about symmetry was a bit puzzling because of the following chart of core annual PCE (the inflation target the Fed is talking about with all this 2% business).
In other words, Core PCE has averaged just over 1.5% for more than 2 decades now, and Fed policy has struggled to coax it above 2% since the financial crisis, even amid the strongest labor market and lowest tax regime in at least as many decades. That poses 2 great questions:
1. What makes them think they even have the power to push inflation above 2%?
2. Even if they do have that power, are they saying inflation needs to average 2.4% for 2 decades?
If such a thing were possible (i.e. a 0.8% swing in average core inflation), the negative effects on the bond market are quite logical. After all, that simply means that the fixed payments that are scheduled upon issuing a bond would be 0.8% less valuable in terms of the “stuff” they could buy in the future. That’s why inflation is classically considered to be the enemy of bonds.
But we’re getting ahead of ourselves. There’s an even bigger question than the two mentioned above. Quite simply: why in the world did the Fed feel the need to unveil this framework shift at yesterday’s (virtual) Jackson Hole symposium? They have an official policy announcement coming up in 2.5 weeks. Are they setting the stage for some as-yet unimagined policy tool designed to further stoke the fires (or smoldering embers) of inflation?
Frankly, that’s the only justification I can think of. Perhaps they were worried it would be too much of a shock to announce a framework change in addition to a forward guidance and/or policy change all on the same day. If that’s the case, they wouldn’t necessarily be wrong about that, but then we have to ask what in the world those changes could be? They’re already pinning policy rates at 0% and they’re already buying a ton of debt.
But there was an important clue in last week’s Fed Minutes and one that I think may hint at what’s going to happen on Sept 16. Here is the section in question:
“In addition, many participants commented that it might become appropriate to frame communications regarding the Committee’s ongoing asset purchases more in terms of their role in fostering accommodative financial conditions and supporting economic recovery. More broadly, in discussing the policy outlook, a number of participants observed that completing a revised Statement on Longer-Run Goals and Monetary Policy Strategy would be very helpful in providing an overarching framework that would help guide the Committee’s future policy actions and communications.”
This is pretty subtle, and perhaps a bit confusing depending on your level of familiarity with Fed-speak, but they’re referring to the fact that current bond buying efforts are technically serving the purpose of ensuring liquidity, “smooth market functioning,” and “effective transmission of monetary policy to broader financial conditions.” In a nutshell, they HAVE BEEN saying they’re buying a ton of bonds because the market needs the help.
If you think that sounds a bit dubious in August as opposed to March (when it was absolutely true), you’re not alone. In fact, the Fed agrees with you! The framework change gives them the leeway to amend their justification. Now they can say they’re buying a ton of bonds NOT because the market needs the help, but rather, because they want to juice the economy (i.e. “foster accommodative conditions and support economic recovery”). It’s all there! Black and white. Clear as Crystal!
Bottom line, after yesterday, no one would be too surprised if the Fed comes out in September and says a more professionally worded version of the following:
“hey folks, we’re going to keep buying a ton of bonds (maybe even more bonds) in order to really fan the flames of economic recovery AND we’re going to keep doing that a lot longer than we would have in the past–I mean hey… we’ll go to 2.5% inflation now instead of that measly 2%. We know we told you this was about smooth market functioning, but that was then and this is now! Let’s go!”