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By John Bellows, Ph.D., portfolio manager, Western Asset
The Fed is becoming more focused on realised inflation and growth and it should remain accommodative even if global growth turns out to be more resilient than currently believed.
Executive Summary
Faced with stubbornly low inflation that has failed to reach the Fed’s 2% target for any meaningful period of time, Fed officials are tweaking the Fed’s reaction function. The Fed is becoming more focused on realised inflation and more growth oriented than at any time in the past five years. We think these changes are likely to prove persistent, and the Fed will remain accommodative, even if global growth turns out to be more resilient than currently feared. Future rate hikes are unlikely to be compatible with the new reaction function.
Key Takeaways
- The Fed’s reaction function may be changing in subtle but important ways.
- The Fed is increasingly focused on realised inflation—concerned about the implications of slower inflation and growth abroad for the outlook in the US—and leaning into the benefits of a hotter economy and tighter labour market.
- The Fed’s evolution toward a new reaction function has been slow and halting at times.
- We expect the new reaction function will become clearer as time goes on; one way in which that may happen is that the Fed could choose to leave rates at a low level, even if global growth defies the current set of fears and remains resilient. The bottom line is that we believe future rate hikes are unlikely to be compatible with the Fed’s new emphasis.
Introduction
The current Federal Reserve (Fed) easing cycle has been frequently described as a form of policy insurance. Fed officials have encouraged this line of thinking by making explicit references to the policies of the 1990s, when rates were cut on two separate occasions in response to concerns about foreign developments. In both instances the insurance proved not to be needed, as the US economy continued to grow without much interruption and, in each instance, the cuts were subsequently reversed about a year later.
While easy to understand, the focus on the experience of the 1990s may be a misleading guide for understanding current Fed policy. At a minimum, policy insurance is not all that is going on this year at the Fed.
The Fed’s reaction function may also be changing in subtle but important ways. The Fed is gradually shifting its framework toward average-inflation targeting, which could significantly change how it will react should inflation move back up to 2%. Fed officials are increasingly vocal about the risks posed by low growth and inflation abroad. Their concern, it appears, is not only about any direct US exposure, but also about the implications of the experience abroad for the future in the US. And Fed officials, Chair Jerome Powell in particular, have started to lean into rhetoric concerning the benefits of a hotter economy and tighter labour market.
“The emerging message is clear: Fed policy in the coming years seems quite unlikely to resemble policies of the 1990s.”