Will Powell signal move to average inflation targeting?

26 August, 2020

Speculation is mounting that Fed chief Jerome Powell will use the annual Jackson Hole conference of central bankers to announce a revamp of how monetary policy is set. The speech, scheduled for the first day of the economic symposium on Thursday at 13:10 GMT, could outline a shift by the Federal Reserve towards average inflation targeting. Powell’s potentially historic address will likely overshadow this week’s economic releases out of the United States. The July numbers for durable goods orders, and personal income and spending are due on Wednesday and Friday, respectively, as well as the second estimate of Q2 GDP on Thursday, all at 12:30 GMT. With bond markets seeing some volatility lately, any surprises by the Fed this week are bound to spur some further gyrations in Treasury yields, and consequently, the US dollar.

Fed mulls average inflation targeting

This year’s Jackson Hole symposium was not initially primed to be a major event by the markets as the Kansas City Fed, which organizes the conference, has moved it online due to the ongoing COVID-19 pandemic. But as the Fed concludes its year-long review of its monetary policy framework, there is a growing expectation that policymakers will unveil their findings at the virtual event, which has coincidently been given the theme “Navigating the Decade Ahead: Implications for Monetary Policy”.

The Fed launched its review on how it conducts monetary policy long before the pandemic as the low inflation environment of the post-financial crisis era has prompted economists to question the usefulness of a fixed and rigid inflation target of 2%. One of the options the Fed has been looking into is to target average inflation over a period of time so that if inflation has been stuck below the 2% goal for some time, policymakers would try and push it higher and let it run above the target for a while to make up for the duration it was trending below it.

Inflation targets have become elusive

Such a move may reduce the risk of ‘killing off’ inflationary pressures as soon as the economy turns hot in the obsession to prevent inflation rising above the widely adopted target of 2%. It may also help boost inflation expectations among consumers and businesses, which after more than a decade, have yet to recover sustainably to pre-financial crisis levels. If the Fed does switch to average inflation targeting, it will probably argue that the overhaul of monetary policy is needed now more than ever following the global economic collapse brought on by the pandemic.

Fundamentally for the Fed, which has a dual mandate of maximum employment in addition to price stability, a more flexible policy would allow it keep interest rates low until the unemployment rate has fallen substantially from the current double-digit levels without worrying about overshooting its inflation goal.

Markets may not be impressed by policy review

Assuming the Fed announces or flags such a change, the question is, will markets be satisfied with this new policy direction or will they turn up the heat on policymakers to set out a more precise forward guidance at the September meeting?

If the yields on long-dated Treasury notes shoot higher after Powell’s speech, likely lifting the dollar up as well, that would imply investors don’t think the Fed has gone far enough in reassuring markets that interest rates will remain low for a very long period of time if they anticipate that the new policy would push up inflation in the long run.

However, if Powell is successful in striking a very dovish tone, whether he achieves that with or without providing details on the policy revamp, yields could fall back from their recently spiked peaks, reviving the selling pressure on the dollar.

Of course, it’s possible investors might be non-the-fussed about the Fed adopting average inflation targeting as many traders might see that as merely a formalization of where Fed policy has been heading anyway in recent years. That would then make the FOMC meeting in September all the more important as it would put the focus entirely on the forward guidance.

Data likely to draw limited attention

Whatever the messages to come out of the Jackson Hole symposium, this week’s data should not be completely ignored amid signs the US recovery is proving to be more resilient than anticipated following the virus resurgence since late June.

A broadly strong set of data from the upcoming releases could further ease worries about a significant hit to the economy from the US second wave. Although if there’s any unexpected weakness in any of the indicators, specifically in personal consumption, this may heighten fears about the potential impact of the looming fiscal cliff as Congress has yet to agree on a new virus relief package.

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