What do you do if you keep missing your target? Should you re-calibrate your approach or simply try harder? What if that also fails? Should you then just change your target? That is what the US Federal Reserve has decided to do with the recent shift in its inflation target. But is the solution really that simple? Are there risks associated with moving the target and what could be the unintended consequences?
By way of background, the Fed’s dual mandate is price stability and maximizing employment. Their favoured measure of price stability is the Core Personal Consumption Expenditure “PCE” Price Index which is just a gauge of the prices Americans pay for goods and services. This “core” measure excludes food and energy. Given the amount we spend on those items it is not clear why the Fed prefers this Core PCE measure but let us leave that question aside for now. Prior to 2012, the Fed announced target ranges of inflation between 1.7% and 2% but in January 2012, the Fed followed other central banks and announced an explicit 2% target. In retrospect this may have been a mistake as the Fed has failed dismally at hitting the 2% target. Despite a decade of record low interest rates and massive monetary stimulus the Fed has only achieved the target for a period of a few months in early 2018.
So here we are in 2020, short term interest rates are near zero, quantitative easing is running at astronomical levels and the Fed has expanded the scope of its asset purchases into all sorts of markets. Yet Core PCE is still stubbornly below target. And so now the Fed has announced that it will adopt a new approach called “average inflation targeting”. They will target average inflation of 2% over a certain period and if it exceeds this level at any point during the period, the Fed will allow it to run higher “for some time”. By not necessarily reacting to inflation when it runs over the target, the Fed believes they will increase the chances of hitting the target longer term. But ironically the direct impact on inflation, at least as measured by Core PCE, may not be that meaningful. Why? Well the experience of central bank intervention, since Japan started experimenting with QE nearly 20 years ago, strongly suggests that central banks are in fact firing blanks when it comes to generating inflation as they measure it.
So where will these impacts be manifested? Mostly likely in asset prices and particularly in those assets which benefit from ultra low interest rates. It also more likely that we could see these moves develop into bubbles as investors anticipate extremely accommodative Fed policy for years to come.
But it might not be the potential bubbles that we should be most worried about. Instead it is bursting of what is arguably the greatest bubble that exists in markets today: bonds. While central banks cannot create inflation, government policy can and the current stimulus measures, if maintained or maybe even expanded, certainly have the potential to spur it. If that happens and the Fed does not react, then how long will bond investors stomach increasingly negative real rates? Many, including some central banks, believe that policies such as yield curve control could be used to prevent a sharp and economically damaging rise in bond yields. While this may be possible, markets have a way of surprising us all. And if yield curve control were “successful” maybe the market’s escape valve will be a de-stabilizing move in currencies. None of us really knows what will happen, but if central bankers were surprised that their efforts to spur inflation failed, they may be just as surprised by their efforts to stem it should it take off. Whatever the outcome, it may not be what the Fed is targeting.
Author: Alex Da Costa