Leading Indicators: What now for the cost of money?

Around this time every year, the world’s leading central bankers congregate at Jackson Hole, Wyoming. Under the auspices of the Federal Reserve Bank of Kansas City, they mingle with economists, financial market participants and academics. The discussion, as you might imagine, tends to the esoteric; while often thought provoking, it rarely fuels much interest outside of the usual rarefied circles. But this year, things were different. For the first time ever, the event was hosted virtually. What’s more, after eighteen months of introspection, the US Federal Reserve (Fed) revealed a series of reforms to its stewardship of monetary policy.

While the announcement of the principal change was not a complete surprise (it had been trailed), it was, nevertheless, hugely significant.  As a result of the exercise, the Fed has now formally adopted what might be best described as an ‘average inflation targeting’ regime. While that may not sound earth-shattering, it does represent a marked change of direction. In effect, it signals that the central bank would welcome (note the word) the inflation rate rising moderately above the existing 2% target for a period of time. This, it is hoped, will compensate for the persistent undershoot of that objective over the past decade.

Alongside this, an even more subtle adjustment was made to the way trends in the labour market are built into the decision-making process. In future, the Fed will base policy judgements on assessments of the shortfalls of employment from its maximum level, rather than deviations from its maximum level. Fed chair, Jerome Powell, explained this as meaning that “going forward, employment can run at or above real-time estimates of its maximum level without causing concern – unless accompanied by signs of unwanted increases in inflation, or the emergence of other risks that could impede the attainment of our goals.”

Despite these changes, it is probably too soon to conclude that inflation targeting has been consigned to the history books. We may, though, have reached a staging post en route to that destination. It is worth recalling that the primacy of this objective in decision making around monetary policy was born in a very different era. I clearly recall the Reserve Bank of New Zealand being an early outrider when, with the inflation rate hovering above 7%, it adopted a targeting regime in 1990. Inflation had featured as a key focal point for policymakers previously, but this added clarity in the form of an explicit mandate. I have to be honest and acknowledge that, at the time, I was far from convinced it would catch on.

One could argue that the approach has actually become a victim of its own success. The strategy was designed to control inflation in a transparent way and secure buy-in from the wider populace. It has, over time, contributed to an environment in which the historic foe seems well and truly defeated. Indeed, the deflationary aura has latterly come to appear particularly powerful. Led by the Bank of Japan (BoJ), numerous central banks have tried, and failed miserably, to generate some level of inflation in recent years.

Now, the question is whether other central banks will follow the Fed’s lead and adopt a more flexible approach to inflation targets. The issue is certainly a live one in Japan with both the IMF and the Japanese Bankers Association calling for more flexibility.

In Europe, the ECB is overseeing a review of strategy that is due to run till the latter part of next year. Its mandate is to achieve what is described as ‘price stability’ – currently defined as an inflation rate that is below, but close to, 2% over the medium term. That will not change, being part of the Treaty on the Functioning of the European Union, but how it is characterised could. The case for moving to an average target is certainly as strong for the ECB as the Fed. Since 2008, core inflation across the Eurozone has balanced out around 1.2%, compared 1.6% in the US. Nevertheless, I suspect that securing an agreement to reinterpret ‘price stability’ will not be straightforward. Not much has so far been said specifically about the issue in public, it is true. But comments from Jens Weidmann, President of the Bundesbank and member of the ECB governing council, hint at a continued commitment to bearing down, rather than tolerating, inflation.

So, going back to the Fed, what do these changes mean in practice? The most obvious conclusion is that interest rates in the US will remain at pretty much zero for the foreseeable future. There have been suggestions that it could be 2024 before there is any change in interest rate policy; if that seems implausible to some, the experience of the BoJ is telling. It is of course conceivable that other tools will be employed first, if there is any justification for putting a foot on the brake. The swollen central bank balance sheet – a result of the quantitative easing programme – could go into reverse should the Fed decide to raise the cost of money directly.

Perhaps more relevant for financial and real estate markets is whether the Fed will be successful in its revamped strategy. The BoJ has demonstrated that jawboning alone is unlikely to be sufficient in generating inflation. The confluence of a couple of macro developments at the present time could, though, make it somewhat easier for the Fed to achieve its goal – COVID-19 permitting. Firstly, I suspect that fiscal activism is here to stay; despite on-going challenges in Congress about delivering CARES 2, a deal is still likely later this month. Second is the oft-discussed shifts around trade and tech which have together contributed so much to the disinflationary environment in recent years.