Tuesday, December 1

Will the Fed Offer More Than Mere Change in Ambitions?

Asian stocks posted modest gains, while European equities have been moderately declining as wait-and-see stance seems to be the most preferable ahead of Jeremy Powell’s landmark speech today. There is some sense that the speech of the Fed head will be some kind of “prelude” before the September meeting, at which the Fed is expected to present its monetary policy 2.0.

If financial markets have correctly interpreted all the recent hints and comments of the Fed officials, Powell should talk about changes in basic goals and definitions. Namely, the concept of “target inflation of 2%” will be replaced by “target range with an average of 2%”. In other words, the Central Bank will allow inflation to accelerate above 2%, which was previously considered undesirable due to fears that lingered from the period of runaway inflation in the last century. Then inflation reached 13% and the interest rate had to be urgently hiked to more than 15%:

But times change, and suppressive influence of technological, demographic, geopolitical factors on inflation is increasing. In other words, it becomes more difficult to stimulate inflation rather than keep it in check. Therefore, the Fed’s past approach to inflation control began to systematically cause inflation undershooting – the proportion of time when inflation remained below the target increased. Therefore, it became necessary to revise the policy, right down to the definition of the goal.

The goal of achieving inflation of 2% on average requires more patience from the Central Bank in terms of raising rates. In other words, monetary policy can remain loose for longer and rise of inflation above 2% may not prompt Fed restrictive response. Hence the rejection, primarily among fixed income investors, of the Fed’s ambitious plans. Expectations of a period of higher inflation make the alternative to reinvesting in short bonds more profitable than in long-dated bonds (since short bonds will adjust to accelerating inflation – offer higher yields), so it can be assumed that the demand for long bonds should now decline, and to grow for short (or at least decrease to a lesser extent). Indeed, in the US yield curve, we can see that it was the far end of the curve that became steeper compared to a month earlier:

It is worth to recall, however, the instructive example of the Bank of Japan, which in 2013 raised its inflation target from 1% to 2%. Did it manage to stimulate inflation then? No, Japan has remained stuck in a near-zero inflation trap. That is, a change in ambitions, as we see, does not at all guarantee that inflation in the future will get where the Central bank needs it, but, undoubtedly, the signal about policy overhaul can cause adjustments of expectations, including in the financial markets in the short term, which we are currently observe.

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