At last month’s Jackson Hole Economic Symposium, the Federal Reserve unveiled their new policy objectives which included the introduction of ‘average inflation targeting’ (AIT) when considering interest rates. The general concept is to let inflation run above a 2% target for stretches of time to balance out the historic period below 2%. This would in turn lead to keeping the current rate around 2%.
It sounds simple in theory: Once inflation rates rise above 2%, the Fed can slowly increase interest rates to slow down the economy and curb inflation. However, in practice it will be far more difficult to manage as indicators used to discern inflation are backwards-looking. As a result, this will provide little insight into what is happening today. It will also be difficult to forecast when these actions will impact markets as it often takes several months for a Fed rate change to have a visible economic impact.
Additionally, the sheer size of the US economy presents another challenge. What might work in one sector may not have the desired effects in another. There is also the management challenge of maintaining a single mandate across a 20 trillion-dollar economy.
Ultimately AIT makes sense for the Federal Reserve at this stage of the economic recovery. For years they attempted to get inflation back to around 2% but found slack within pockets of the labor market. This depressed wage growth and also kept inflation lower despite record low unemployment rates. Now, with increased unemployment and interest rates at zero, they are revisiting how to navigate inflation in the coming years.
As tomorrow’s FOMC meeting concludes, more details will emerge regarding AIT and how the Fed plans to implement policies which help manage inflation. There will almost certainly be no change to the current policy, especially since Congress has been unable to deliver an additional pandemic-related stimulus package.
Therefore, the FOMC meeting will hopefully be more informational as to the future of the Federal Reserve policies and shed light on immediate action. Active traders should understand that any changes to current policies will likely disrupt markets and cause some unexpected volatility.
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