The Federal Reserve has undershot their inflation goals for eight years. They recently threw out their rulebook and embarked on a new strategy. Only time will tell if it gets them the inflation they seek, but it seems certain to embrace greater risk in the process.
Up to this point, Federal Reserve policy was to arrest the onset of inflation by raising interest rates preemptively. It was through this policy lens that they began raising the overnight rate throughout 2016-2018 as economic growth picked up. Economic models used by the Federal Reserve then and now suggested greater growth and low unemployment would lead to more inflation. Only it didn’t this time. Then came COVID-19 and overnight rates went back to zero.
For more than a year, the Federal Reserve has been reviewing its monetary policy strategy. They conducted listening tours throughout the country, seeking input from interested parties and recently announced their conclusions. Henceforth, instead of raising rates to address expected inflation, they will let inflation run hot for a while before raising rates. They will move from defense to offense and will apply their 2% inflation target as an average rather than a ceiling.
For those who pay little attention to Fed policy, this may not seem like a big deal. But it could be. Think of inflation like a prairie farmer burning his grasses. The metaphor isn’t perfect. Farmers engage controlled burns to help material decompose faster to return important nutrients to the ground and help seeds germinate. Inflation has no similar benefits, in fact it slowly destroys the value of money. But it does require vigilance to keep under control. Much like the farmer must ensure his prairie fire stays manageable as the first line of defense against a larger problem, so too does the Fed have to keep an eye on inflation.
Under the new policy, you can imagine the Fed casually watching their inflation fire burn from the sidelines as they busy themselves with other issues. The deceit is that once they let inflation run hot for any length of time, they can simply step in when necessary to reassert control. The Federal Reserve has been unable to generate sufficient inflation over the last decade. The idea they can dial inflation levels up or down on a whim seems a stretch.
Further complicating matters, the Fed provided little clarity on several aspects of their new policy. How high will they let inflation go before they step in? How long will they let inflation rise before they take action? For an institution that emphasizes clear communication to guide monetary policy, their commitment to greater discretionary decision-making is a questionable U-turn.
The upshot for investors is the volatility likely to accompany this new policy. We have become accustomed to the upside of volatility with rising markets and lower interest rates. What concerns us are the effects of volatility when markets start moving the other direction. Metaphorically speaking, we are concerned the Fed just added a little too much more fuel to the inflation fire.