Back in high school, I ran hurdles. I wasn’t very good, but got a spot on the track team because no one else wanted to do hurdles. I quickly discovered why: It’s hard, and a small mistake makes a huge difference in your time. Plus, the practices were brutal. The better you got, the higher the hurdles. Sprinters got to run their hearts out, and the distance runners got to experience the “runner’s high.” Hurdlers were lucky to avoid falling down. There were a lot of bruises.
There’s a good chance that the Federal Reserve is in for a few bruises in the months and years ahead as it raises the acceptable hurdle rate for inflation. After a long review of its policy framework, the Fed announced it is shifting to an “average inflation target” of 2% rather than a precise target. Rather than tighten policy pre-emptively when it sees inflation moving above 2%, it plans to hold interest rates steady for some time, allowing the economy to run a little “hot” at times, after being “cool” for a long time.
The immediate question that comes to mind is, “How will the Fed raise inflation?” After all, what good does it do to raise the target if you’ve been undershooting it for years? Core Personal Consumption Expenditures (PCE), which the Fed uses as its benchmark inflation measure, has spent most of the past 12 years below the 2% target.
Inflation has fallen short of 2% for most of the past decade
Source: Bloomberg. Personal Consumption Expenditures: All Items Less Food & Energy (Core PCE) (PCE CYOY Index), percent change, year over year. Monthly data as of 7/31/2020.
We believe the Fed will have a difficult time pushing up inflation, but inflation expectations are likely to continue to rise due to the change in the way the Fed will react to potential inflation. In fact, the Fed’s new stance is actually more focused on jobs than inflation. In his policy speech, Fed Chair Jerome Powell talked extensively about employment and the importance of the Fed doing all it can to support job growth. A part of the Fed’s review of its policy was a “listening tour” during which it engaged in discussions about the economy with communities across the country. The overwhelming message was that a strong labor market is important for improving the lives of individuals and the overall economy.
With that message and years of overestimating inflation based on the “natural rate” of unemployment, the Fed has abandoned its old framework and will not pre-emptively raise interest rates just because the unemployment rate falls below a predetermined level.
High unemployment is one of the Fed's biggest concerns
Source: Bureau of Labor Statistics. Civilian Unemployment Rate and Underemployment Rate, Total unemployed, plus all marginally attached workers plus total employed part time for economic reasons (U6 Rate), Percent, Monthly, Seasonally Adjusted. Shaded area indicates recession. Monthly data as of August 2020.
With the unemployment rate in double digits, pre-emptive rate hikes wouldn’t have been on the agenda anytime soon, anyway. However, the change is important. The Fed has thrown the Phillips curve (which describes the relationship between employment and inflation) into the dumpster. Whether it’s due to the effects of globalization, the decline in unionization, or the rise of service sector jobs over manufacturing jobs, wage growth has slowed relative to productivity growth over the past few decades. This has resulted in a decline in labor’s share of gross domestic product (GDP). Consequently, economic growth doesn’t necessarily translate into money in the pockets of those most likely to spend it—lower- and middle-income workers. Without a pocket full of money to drive up demand for goods and services relative to supply, a low unemployment rate doesn’t necessarily lead to inflation.