The US Federal Reserve has failed to consistently reach its inflation target for well over a decade now.
Despite a recent change of framework in the right direction, there is little to suggest success in this arena is imminent, writes Mark Harris, head of multi-asset at Garraway Capital Management.
Dual mandate
“Will the Fed’s ultra-easy policies actually stimulate accelerating economic activity, or just pump up asset prices and make the stock market happy?”
This question, posed by Mickey Levy of Berenberg, is one we have spent a lot of time considering lately.
Since 1977, the Fed has operated under a mandate to “promote effectively the goals of maximum employment, stable prices, and moderate long-term interest rates”.
This is commonly referred to as its “dual mandate”.
With this dual target as their goal, it is not a surprise the Fed continues to believe in the trade-off between unemployment and wage growth. In fact, it has clung onto the notion of the Phillips curve, which attempts to explain the link between these two factors.
The Phillips curve is an economic concept developed by A. W. Phillips stating that inflation and unemployment have a stable and inverse relationship. The theory claims that with economic growth comes inflation, which in turn should lead to more jobs and less unemployment.
While the Fed adheres to this concept, all the real-world experience and statistical evidence suggest it is barely valid in the US, and it does not apply in other developed countries.
Epic fail
In January 2012, the Fed evolved its longer-run goals and monetary policy strategy. They judged that inflation at the rate of 2% (as measured by the annual change in the price index for personal consumption expenditures or PCE) would be most consistent over the longer run with the mandate.
Yet despite record unemployment, inflation has not picked up materially in many years.
In fact, the Fed has not reached their inflation target for more than a few months in the past 12 years. Moreover, they have offered up little by way of explanation for this epic fail.
However, we may finally have a glint of light with Fed chairman, Jerome Powell’s, speech at this year’s virtual Jackson Hole meeting. His change in direction is one which investors should monitor very closely.
Fed official, Richard Clarida, commented that the change “reflects the reality that economic models of maximum employment, while essential inputs to monetary policy, can be and have been wrong”. The Fed under Powell’s leadership has finally recognised this and has conducted its first ever public review of the monetary policy framework under the banner of the “Fed listens”.
The result has been further evolution to include a more “broad-based and inclusive goal” for maximum employment and the flexible use of “average inflation targeting” which allows them to “aim to achieve inflation moderately above 2% for some time” following periods when inflation has been below that level.
Unfortunately, we feel it will come down to luck whether they will be able to generate sufficient inflation given they have yet to offer a coherent explanation of the current environment and its drivers. Without such an explanation how can one expect the Fed to remedy the issue?
No interest in raising rates
Now, the Fed are operating in an environment where the fiscal axis has shifted from austerity to stimulus. Officials are turning their attention to what ways they can provide more support to the economy after cutting rates to near zero in response to the downturn caused by the coronavirus pandemic.
They are buying Treasury and mortgage securities at a rate of more than $1trn (€854bn) a year and have signalled no interest in raising rates for years.
The danger, as we have also been at pains to point out, is that the Fed remain so far behind the curve that they eventually risk unleashing the inflation expectation anchor. This is most definitely not priced or being reflected in investors positioning.
We remain bullish on risk assets given ultra-easy monetary policy and the potential for more fiscal stimulus.
We retain our optimistic stance on the outlook for gold and gold equities given the change in direction noted above and believe caution on sovereign bonds is warranted.
This article was written for Expert Investor by Mark Harris, head of multi-asset at Garraway Capital Management.
