The Fed has adopted a new inflation reaction function called the “flexible average inflation target” (FAIT) for which the goal is to average 2% inflation. This means that an inflation overshoot is warranted after a period of inflation undershooting. In essence, the Fed shifted to a “makeup” inflation strategy from the prior “bygones” inflation policy. Under this new framework, what can be expected from the Fed this year? Below we discuss some key questions.
Will the Fed really wait for inflation?
The short answer is yes. The Fed has a goal of averaging 2% inflation under the FAIT framework, so by definition, inflation has to overshoot 2% for a period to offset recent periods of undershooting. Expect the Fed to look for signs of persistent inflation, higher inflation expectations and “sticky” realized inflations. It still should be a couple years before the first Fed rate hike, but the risk is for hikes to come sooner rather than later given the prospects for additional fiscal stimulus to spur growth.
When will the Fed taper?
The Fed, through a form of forward guidance, has linked asset purchases to economic outcomes, particularly higher inflation. This allows balance sheet policy to reinforce FAIT. Expect the Fed to wait for greater progress on its core PCE objectives before it considers tapering. As we get closer to tapering, the Fed will offer early guidance and try its best to keep taper optionality. As with rate hikes, the risk is for earlier than expected tapering due to more supportive fiscal stimulus.
Will the Fed push back on long-end rates?
This is a nuanced question. If rising rates reflect a better economy, then the Fed should embrace that. However, if the rise in rates is driven by “unhealthy” factors, such as a hawkish policy mistake or market liquidity issues, then expect the Fed to fight against that.
What guidance will the Fed provide through its projections?
A key development will be inflation overshoots in forecasts. It is also worth paying attention to the charts showing the distribution of risks, with a shift to the upside being an important signal.
What about financial stability, inequality and the climate?
Financial stability is likely the most pressing of these issues with ultra-low rates under the Fed FAIT framework. Inequality and climate change have also taken increased importance with the Fed. Inequality argues for keeping monetary policy accommodative, while climate change will likely be addressed through regulations. | |
| HERE ARE THE KEY NEWS STORIES FROM OVERNIGHT: | |
- President-elect Joe Biden unveiled his $1.9 trillion fiscal package yesterday, with reports indicating the Biden administration is working on another spending package that will include infrastructure and address climate change.
- Fed Chair Jay Powell underscored his dovish tilt in comments made yesterday. The Fed chair made it clear that “now is not the time to be talking about” exiting accommodative policies. In total, this week saw the power trio of Powell, Clarida, and Brainard push back against talk of tapering from some regional Fed presidents.
- U.S. retail sales fell for a third month, as December retail sales were down 0.7% month over month against expectations for a flat reading.
- U.K. data out this week underscored the ongoing weakness in the economy. With virus numbers continuing to rise, first-quarter GDP is likely to contract, which means additional fiscal and monetary easing is likely on the way. On the monetary front, some of the more dovish members of the Bank of England (BOE) have brought up the notion of negative rates, but BOE Governor Andrew Bailey and other internal members have pushed back against negative rates.
- The U.S. has blacklisted nine more Chinese companies due to their alleged ties to the Chinese military. In total, 60 companies are on this blacklist.
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