Wall Street is still weighing the implications of the Federal Reserve’s most significant change in the way it thinks about monetary policy in years.
In essence, Fed Chairman Jerome Powell on Thursday stressed the primacy of the labor market in his tenure, even if that means inflation exceeds an annual target of 2% that the central bank has traditionally seen as a sign a healthy and well-functioning economy. .
“This change may sound subtle, but it reflects our view that a robust labor market can be sustained without sparking inflation,” Powell said in his web address at the annual Jackson Hole Symposium on Thursday. . Indeed, change is a big deal according to experts, and not just because of the defenestration of decades of central bank orthodoxy focused on the relationship between the labor market and price pressures, but because it expresses a policy which can be very far from a policy. as advocated by Stanford University economist John Taylor, who advocated a mathematical approach to setting interest rates.
The Fed’s new approach, on the contrary, may raise more questions than answers about implementation and, crucially, how it is meeting inflation targets that have so far remained elusive over the course of the year. of the last decade.
“What inflation is the Fed comfortable with?” Jefferies chief economist Aneta Markowska asked in a research note Friday.
“The FOMC has been surprisingly vague about its framework for averaging inflation, simply stating that it will aim to achieve inflation ‘moderately above 2% for a while’ after periods of under-inflation. overtaking. What does this mean in practical terms? We just don’t know, ”the economist wrote.
After Powell’s Jackson Hole speech, some Fed officials attempted to give some idea of the degree to which inflation might be allowed to exceed the central bank’s target before sounding the alarm.
“To me, it’s not so much the number, whether it’s 2.5% or 3%,” FOMC voting member Patrick Harker, Philadelphia Fed Chairman, told CNBC in an interview on Friday. “It’s about reaching 2%, going up to 2.5% or going over 2.5%,” he said.
St. Louis Fed Chairman James Bullard, who is not currently a voting member of the FOMC, said on Friday inflation could stay around 2.5% “for a while”.
Inflation plays a key role in Fed policy, as too low inflation can lead to a weaker overall economy, as it can encourage consumers, the main engine of the US economy, to delay purchases, as well as ‘to amplify even lower price expectations, potentially creating a vicious cycle. As the Fed put it, “If inflation expectations were to fall, interest rates would also fall.
And the fall in interest rates is preventing the Fed from using its main tool in managing monetary policy: the federal funds rate. The Fed lowers its benchmark interest rate to stimulate economic activity and raises it to slow it down.
It should be noted that the Fed raised interest rates nine times between 2015 and 2018.
However, since at least 2009, price pressures have not been seen anywhere, based on expected 5-year and 5-year breakout points of inflation, which are at 1.6%. This measure of inflation calculates the expected pace of price increases over the five-year period that begins in five years.
A lack of clarity on the specifics of its modified policy could inject more uncertainty into the market in the long run, experts said.
“Regarding the change in the way the Committee views its inflation target, a lot has not been said, and close examination suggests that the new approach may actually complicate the political process in terms of setting implementation and communication, ”Robert Eisenbeis, chief monetary economist at Cumberland Advisors, in a note Friday.
Eisenbeis says the Fed did not immediately say what measure of inflation it would use. Traditionally, the central bank’s preferred inflation gauge has been the PCE price index, or the price index for personal consumption expenditure, but the gauge commonly referenced on Wall Street is the CPI, or price index. the consumption.
“Finally, the elephant in the room is the fact that the [Fed] has pursued a 2% inflation target since Jan. 25, 2012, but has consistently below that level, ”Cumberland analysts wrote.
What are the prospects?
“The Fed will now have to really explore this new regime change at the FOMC meetings, because it’s great to tell us that they plan but how they act is what the market really needs to learn,” wrote Chris Weston, research analyst at brokerage Pepperstone.
Lara Rhame, chief US economist at FS Investments, says the implications of the Fed’s measures may not materialize until the end of the COVID-19 crisis.
“The real problem for investors will be what comes after this economic crisis,” the economist wrote.
“Many are hoping that over the next two years the economy will continue to recover. This could happen even faster if a vaccine or more effective treatments help suppress the pandemic, ”FS Investments analysts said.
” More [Thursday’s] The announcement made it clear that even a return to steady potential growth would mean the Fed would likely leave rates where they are – zero, ”the economist said.
The next Fed policy meeting September 15-16 may fill some of the blanks for market participants.
Implications for markets
So what does all of this mean for the financial markets?
This implies a potentially lower interest rate regime, but expectations of market volatility may rise, without further guidance on how the Fed’s policy will play out.
In the near term, stocks could continue to rise or at least be inclined to remain stable, with the Fed more explicitly indicating that it has no plans to raise interest rates anytime soon.
“One of the few things that could have turned the market around was that the Fed could start raising rates… I don’t know if that [policy shift] is going to lead to a further merger, but I certainly think it puts a safer base under the market, ”Brad McMillan, chief investment officer at Commonwealth Financial Network, told MarketWatch.
Friday, the Dow Jones Industrial Average DJIA,
closed around 3% from its all-time high on February 12, while the S&P 500 SPX,
et le Nasdaq Composite Index COMP,
both finished with records.
“It’s tough to bet against the stock market right now,” David Donabedian, chief investment officer of CIBC Private Wealth Management, said in email comments.
McMillan, from the Commonwealth, also said growth stocks, which have notably been in shambles, are likely to continue to benefit from the low interest rate regime in the near term. “Future cash flows are going to be worth more in the present to companies that can generate them,” he noted.
“Companies with pricing power, like commodity stocks, will benefit. Banks will finally benefit from an increasingly steep yield curve. For those who do not have pricing power and therefore have to eat up increasing cost pressures, profit margins will be reduced and that will not be a good thing ”, wrote in a note Friday Peter Boockvar, director investments at Bleakley Advisory Group.
“Cheap stocks, which is called the value side, already inherently built in low expectations, so they would be more immune. Interesting moments, ”he says.
BofA Global Research analysts including Michelle Meyer said they did not expect the US dollar DXY to rise significantly,
after Powell’s statement.
Analysts wrote in a report on Thursday that “a large rally in the USD may finally be contained in the absence of another episode of risk aversion, as USD shorts have been concentrated in the community of asset managers generally less price sensitive. ”
In theory, lower interest rates and higher inflation over the longer run should support gold and silver prices, which have already attracted significant safe-haven flows as investors worried about economic implications of the coronavirus on business activity around the world.
and SI00 silver,
to a lesser extent, are seen as hedges against uncertainty and rising inflation. The weak US dollar, or at least a stable greenback, could also help support precious metal prices.