The Federal Reserve announced a major change in strategy as the US central bank found itself largely missing its 2% inflation goal since it began targeting a 2% rate from 2012. Instead of aiming for inflation to hit 2%, it will now aim to see inflation average 2% over time.
“Following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time,” announced the Federal Reserve on 27 August 2020, updating its Statement on Longer-Run Goals and Monetary Policy Strategy.
Another dovish shift from the Fed was that it would now consider ‘shortfalls of employment from its maximum level’ rather than ‘deviations from its maximum level’ when setting intereast rates. This means that it will not necessarily begin raising interest rates to a level that it considers consistent with full employment. The Fed defines around 4% of the labour market as the market being in a state of “full employment”, with current US unemployment rate still above 10%.
Fed chairman Jerome Powell stated that the Fed would not tie its policymaking to meeting a specific set numeric level of unemployment. Nor would the central bank, he added, be welded to a particular mathematical formula that defines the average for its new inflation targeting strategy. “Our approach could be viewed as a flexible form of average inflation targeting,” he says.
“We expect the new dovish strategy may lead to the Fed keeping its fed funds interest rate at 0.00-0.25% for up to the next five years now,” says BOS Chief Economist Mansoor Mohi-uddin. Nevertheless, the Fed, he says, has given itself sufficient space to keep setting interest rates as the economic outlook evolves.
Based on this announcement, the Fed will likely provide new forward guidance that leaves the fed funds rate unchanged until inflation returns to 2% on a sustained basis, says Mohi-uddin. Policymakers must also forecast inflation to be above 2% over the subsequent 1-2 years.
“The Fed’s shift will thus continue to support risk assets and weaken the USD by keeping interest rates even lower for longer. The yield curve will steepen as inflation expectations rise. But yields will still stay very low,” writes the economist. He sees EURUSD coming in at 1.25 and ten-year yields at 0.90% over the next year.
