New Approach Set to Lead to Kinder, Gentler Fed – September 1, 2020

On Thursday, the Federal Reserve announced a new policy regarding how it will handle inflation, which could keep interest rates low for a long time.

Its new stance, which is being implemented based on long-term changes in the economy, won’t have an immediate impact. You see, the Fed has already said it plans to hold the fed funds rate near zero for an extended period.

But it could have major implications for savers and borrowers longer term.

What is behind the Fed’s change? In his speech, Fed Chairman Jerome Powell said, “The persistent undershoot of inflation from our 2% longer-run objective is a cause for concern.”

He quickly added, “Many find it counterintuitive that the Fed would want to push up inflation. After all, low and stable inflation is essential for a well-functioning economy.”

Yet, there is a concern at the Fed that ‘too-low inflation’ could lead the U.S. economy to fall into a trap that has plagued Japan for decades, and more recently, Europe.

How is inflation measured? The Fed, investors, analysts, and economists measure inflation using what’s called the Consumer Price Index or the less familiar but broad-based PCE Price Index. These detailed metrics influence interest rates, Fed policy, and stock prices.

Over the last 40 years, the rate of inflation has slowed. During the last expansion, inflation averaged just 1.6%, well below the Fed’s 2% target.

Bottom line, the Fed will maintain its 2% inflation goal. But it no longer plans to preemptively lift rates to stave off the possibility inflation could move higher, as it has done in the past.

If the new policy had been in place during the last cycle, we likely would have seen far fewer rate hikes than the nine quarter-percentage point increases in the fed funds rate.

The Fed will also allow inflation to overshoot 2%, helping to average out inflation if it has previously undershot 2%. In other words, it may tolerate a little bit of inflation in order to keep downward pressure on the jobless rate.

There are risks that rates that are too low in an economic boom could create speculative imbalances, and the Fed said it could react. However, the new policy is important because low interest rates, without an unwanted rise in inflation, have historically been a tailwind for stocks.

Created 2020-09-01 16:01:05