Fed to Allow Inflation To Shoot Higher

On the sixth day of October 1979, the Fed changed the way it looked at inflation – more precisely, the target and how to manage inflation. It came in the aftermath of the Nixon shock, and it was a game-changer for a world forced to trust a USD not backed by gold. 

Fast forward four decades and yesterday’s Fed’s announcement has the potential of having a similar or an even bigger impact for financial markets. The Fed reviewed its monetary policy framework and used the Jackson Hole Symposium as the event to announce its findings. This is not the first time the Fed delivers important decisions at Jackson Hole. Only this time, the message has a chance to make history.

Changes in the Fed’s Framework

Unlike other central banks in the developed world, the Fed has a dual mandate. On the one hand, it vows to maintain price stability. On the other hand, it aims to create jobs.

Faced with the coronavirus economic crisis and having rates already to the lower boundary, the Fed needed to do something different. For years, it fought to bring inflation to the 2% target, but failed miserably as the developed world faced crisis after crises (e.g., 2008-2009 Great Financial Crisis, 2012 European sovereign crises, the tech bubble in the 90s, and so on).

A change, therefore, was due, according to the Fed. And yesterday we found out the details.

The most important change comes from the price stability part of the mandate. The Fed switched to 2% average inflation over time, which is a bold move from what it used to look at inflation. Average means considering past inflation, as well as the future. Also, to reach an average of 2%, it means that the Fed is willing to let the current inflation overshoot the 2% level significantly.

If current inflation reaches four percent and past inflation was zero, the average around 2% would not warrant a rate hike or a policy shift from the Fed. Up until now, every time inflation reached close to zero, or inflation expectations hinted towards that, the Fed changed its tone to hawkish. A rate hike or even a tightening cycle would eventually come.

The Fed plays a dangerous card, but if there was a crisis to play such a hand, this current crisis is certainly the one. This is uncharted territory for the most proactive central bank in the world.

It remains to be seen how the market perceives the changes. Will other central banks follow?

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