• August was atypically busy for broad financial markets
  • Fed Chair Jerome Powell unveiled a new monetary policy framework during his annual Jackson Hole address, including a shift to average inflation targeting
  • Despite various distractions in recent weeks, COVID-19 remains the predominant driver of the current economic outlook

August is typically a quiet month for financial markets, as participants sneak in one last summer vacation before school starts back. Trading volumes are typically lighter, and any major monetary policy announcements would normally wait until at least after Labor Day. However, if we’ve learned anything this year, it’s that 2020 is about as far from normal as it gets. Rather than wait until the September FOMC meeting, Fed Chair Jerome Powell unveiled a new monetary policy framework for the central bank during his August 27 Jackson Hole speech, which further expands the current dovish policies. The Fed has been engaged in a review of its policy framework since November 2018, and a major consideration has been a shift to an average inflation targeting approach.  In line with our expectations, Powell announced just that, and the Fed simultaneously released a new Statement on Longer-Run Goals and Monetary Policy Strategy.

Before detailing this new approach, it would perhaps be helpful to provide some additional context and perspective. There have been multiple economic developments culminating for more than a decade driving this policy shift, including the longer-term trend in GDP growth and productivity for the U.S. and the rest of the major developed economies. This is due in part to demographic factors, including declining birth rates and aging populations. The neutral (or natural) rate of interest, or R-star, which is the theoretical fed funds rate that is neither accommodative nor restrictive, has been falling for much of the last two decades, which coincides with the longer-term decline in the trend GDP growth rate. Exhibit 1 looks at both metrics over the last 30 years using estimates from the New York Fed. In this environment with a policy rate effectively floored at the zero bound, the Fed has contemplated various approaches. At the onset, raising the inflation target was not under consideration, and current leadership has made their opinion clear that a negative policy rate would not be beneficial. Instead, the Fed has preferred to focus on enhanced forward guidance, asset purchases, and, potentially, yield curve control.

With average inflation targeting, inflation would be allowed to run hot (above the 2% target) in the short run in order to support the economy. “Following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time,” Powell explained in his 8/27 speech. Some economists have referred to this as the “makeup” approach because the central bank is attempting to make up for past deviations from the 2% target, in both directions. A primary goal of average inflation targeting would be to lift inflation expectations. For example, by removing the 2% cap on the current guidance, inflation expectations may be less likely to fall following an economic shock, particularly when the policy rate is floored by the zero bound.

This announcement was well received by risk markets because it is yet another dovish move by the Fed, and as such, the Treasury curve steepened. Regarding the latter, it will be interesting to see how much steepening the Fed is comfortable with before revisiting the topic of yield curve control. Nevertheless, the next major event will be the September 16 FOMC meeting. With this new policy framework in place, it’s likely that the Fed will modify the forward guidance in the official statement to account for this new inflation targeting approach.

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