The Federal Reserve announced a major change last night by shifting from its current strategy of aiming for inflation to hit 2% to seeking for inflation to average 2% over time.
This is in response to the Fed largely missing its 2% inflation goal since it began targeting a 2% rate from 2012 as the chart above shows. Thus, the Fed observed: ‘following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.’
The Fed made the change by updating its Statement on Longer-Run Goals and Monetary Policy Strategy. It also announced a second dovish shift by noting it would now consider ‘shortfalls of employment from its maximum level’ rather than ‘deviations from its maximum level.’
This means the central bank will not necessarily start raising interest rates once unemployment - which is currently still above 10% - falls to levels that the Fed considers to be consistent with full employment at around 4% of the labour market.
Fed Chair Powell spoke immediately after the changes were announced and said the central bank would not be tied to meeting a specific numeric level of unemployment. He also said the Fed would not follow ‘a particular mathematical formula that defines the average’ for its new inflation targeting strategy. Instead he observed: ‘our approach could be viewed as a flexible form of average inflation targeting.’
Thus, the central bank has given itself sufficient space to keep setting interest rates as the economic outlook evolves over time. But we expect the new dovish strategy may lead to the Fed keeping its fed funds interest rate at 0.00- 0.25% for up to the next five years now.
The next step is for the Fed to put into practice its new strategy. At its next meeting in September, the Fed is likely to commit to new forward guidance that leaves the fed funds rate unchanged until inflation first returns to 2% on a sustained basis and policymakers forecast inflation to be above 2% over the following 1-2 years. The Fed’s shift will thus continue to support risk assets and weaken the USD by keeping interest rates even lower for longer. The yield curve will steepen as inflation expectations rise. But yields will still stay very low. We see EURUSD at 1.25 and 10Y yields at 0.90% over the next year.Disclaimer applicable to recommendation
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