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Economic Insights

With both U.S. interest rates and inflation at low levels, the U.S. Federal Reserve Board (Fed) frets about its ability to manage economic downturns.

Since the Great Recession of 2008-09, the zero lower bound (ZLB) (or what the U.S. Federal Reserve Board [Fed] calls the “effective lower bound”)— when short-term interest rates are at zero and thus cannot be cut further—has moved from being a textbook curiosity to a clear risk for policymakers. In recent years, several eurozone economies have entered prolonged spells at the ZLB, as has Japan (which has been stuck at the ZLB for most of the past two decades).

ZLB is a problem for central banks because, in recent decades, a reduction in short-term interest rates has become the primary policy tool used to fight recessions and spur recoveries. If nominal interest rates (i.e., rates not adjusted for inflation) are at or approaching zero, a central bank has less room to cut rates to stimulate growth in a downturn.

In the aftermath of the Great Recession, with nominal interest rates at historically low levels, the Fed was up against the ZLB and decided to adopt unconventional policy measures, including three rounds of asset purchases (known as quantitative easing) to stimulate the economy.

Fed board members are now convinced that nominal interest rates are unlikely to rise as high as they have in the past, even in periods of economic growth. The underlying trends contributing to this development—such as aging populations and income inequality (with a consequent shift from consumption to savings), along with a reduced pace of technological innovation—do not seem likely to reverse anytime soon.

So the Fed is looking for new ways to respond to downturns.

Managing Expectations
In early June 2019, Fed members met in Chicago to discuss policy change options that could meet the challenge. And based on public pronouncements to date, a change in inflation targeting strategy (which is currently at 2%) is likely under consideration. Today, there is a renewed focus on inflation expectations, which Fed Chairman Jerome Powell called “the most important driver of actual inflation” in his testimony before Congress on February 26, 2019. “We need to make sure inflation doesn’t keep slipping down toward zero, because then the central bank really does have less and less ability to react to downturns.”

Although the Fed has always used some kind of implicit inflation rate target, it did not turn to an explicit 2% target until 2012. In fact, the Fed was late to the party. Inflation-rate targeting has been used by other central banks since the 1990s. The central banks of New Zealand, Canada, and the United Kingdom were among the first in 1990, 1991, and 1992, respectively. As to the success of inflation targeting as a policy, the experience has been variable. The Bank of England, for one, has to write a letter every time it misses the inflation target, and it tends to write a lot of letters.

The United States has experienced an extended period of inflation below 2% since the Great Recession in 2008, and has had a disappointing record of meeting a 2% target (implicit or explicit) since then (as of May 31, 2019). On a year-over-year basis, core personal consumption expenditures (PCE) inflation has been above target in only six months since October 31, 2008, according to the Bureau of Economic Analysis, and only one month since 2012. Over this period, consumer inflation expectations have drifted to low levels – a trend that, if it continues, will undermine the 2% target as an inflation anchor in the future, according to New York Fed President John Williams.

 

Chart 1. The Fed’s 2% Inflation Target Remains Elusive 
Core PCE Index (January 1, 2012-April 30, 2019) 

Source: BLS, Bloomberg.

 

The Fed says its current 2% inflation goal is meant to be a symmetric target around which inflation fluctuates. But if that were the case, according to Boston Fed President Eric Rosengren in an April speech “we would expect to see a more balanced distribution, with a roughly equal number of observations above and below 2%.”  (Rosengren has called for adopting an inflation range of 1.5% to 2.5%.)

The Fed’s current policy is referred to as an inflation target policy without memory.  And that is because, regardless of what actual inflation has been in the prior year (whether inflation has been below or above 2%), the Fed’s target for the next year will again be 2%. In the words of Mike Carney, Governor of the Bank of England, it lets “bygones be bygones.”

The current policy has the benefit of being easy to understand—no small thing when trying to manage  the market’s inflation expectations. But the target is a sustained, specific level of inflation, and the policy doesn’t require the Fed to make adjustments when that target is missed.   

Options on the Table
The Fed is now considering other options. The two most often discussed are price-level targeting and average-inflation targeting.

Price-level targeting calls for the Fed to react to what happened in the prior year, which is, in effect, a policy with memory.  So if inflation undershoots the 2% target in the prior year, the Fed will try to catch up by allowing an overshoot in the next year. It would do so by keeping interest rates lower for a time, providing an extra boost in order to get the inflation rate back up.

Average-inflation targeting calls for the Fed to keep the inflation rate at the target level on average over a period of time, for example, over a business cycle. This means that inflation would need to be a bit higher than the 2% target during boom periods to make up for an expected shortfall during downturns.

Most observers expect the Fed to favor average-inflation targeting as a policy.

Advocates of any inflation targeting policy claim it leads to increased economic stability by helping to manage inflation expectations. When a policy is clearly communicated, they say, investors are less likely to be surprised when a central bank makes the decision to raise or lower a key interest rate, hopefully reducing the potential for market volatility. An inflation targeting policy also makes sense in light of the Fed’s dual mandate from Congress: full employment and price stability. If the Fed is trying to maintain price stability, obviously it needs to define what target level would constitute stability.

Potential Investment Implications
What’s important to all of us are the potential investment implications that a policy change could bring about. If the Fed adopts either the price level targeting or the average inflation targeting, inflation expectations would probably rise given that the central bank is trying to target a higher inflation rate during normal times. Hence, in terms of inflation breakevens (a market measure of expected inflation), expectations may rise. Just the uncertainty of a new policy being implemented is likely to increase the risk premium—not only the term risk premium but also the inflation risk premium in breakevens.

At the same time, because on average the Fed will probably be keeping rates lower than in the past, such a policy change could push the real interest rate lower. That, in turn, would be a boon for inflation-related products. It will have some investment implications for Lord Abbett, namely, our positions in Treasury Inflation-Protected Securities, or TIPS. In addition, the slope of the U.S. Treasury curve may change. If investors think, on average, that inflation will be higher than it has been, the knee jerk reaction would be a steeper curve. But that will depend on the specifics of the policy.

If the time comes and inflation expectations move in a major way, that could have significant implications not just in terms of investment but also in terms of the economy in general because higher inflation expectations for the future tend to promote consumption today. As the consumption rate grows, alpha tends to grow—with investment as well as economic implications.

For the U.S. economy in general, low inflation and interest rates at the ZLB are not necessarily a bad thing.  The late economist Milton Friedman suggested that the optimum economic scenario for an economy is slight inflation and nominal interest rates at zero.  But it’s difficult for the Fed to meet its mandate if a recession happens in an environment where interest rates cannot be lowered to help stimulate the economy.  The United States is close to a ZLB interest-rate environment today.

Stubbornly Low Inflation
Fed officials seek 2% inflation because they see it as consistent with healthy growth.  In our opinion, the economy is likely to run better when businesses and consumers behave as if inflation will even out over time despite short-run ups and downs.

With low unemployment and fiscal stimulus from tax cuts, most forecasters thought inflation would be running comfortably at the Fed’s 2% goal by now. Instead, excluding volatile food and energy categories, inflation fell to 1.5% in April, 2019, from 2% in December, 2018. This raises concerns that households and businesses will think the Fed isn’t committed to its stated goal, leading them to expect even lower inflation in the future.   

That appears to be what the Fed is worried about. Like the Bank of Japan and the European Central Bank before it, will the U.S. central bank struggle to generate more inflation, i.e. stimulate the economy, with interest rates already near ZLB and inflation expectations so low?   

Of course, all of this becomes of greater concern should a recession develop in the United States.  On that point, we still think the current U.S. economic expansion has a way to go and recession is not an imminent threat.

High Credibility
If the Fed wanted to consider any change in its long-term monetary policy, right now may be the time to do it.  Today, the Fed can say it is successfully meeting its dual mandate, and its credibility might be at the highest level it has been.  It’s potentially the right environment to make any sort of change.

Although we do not expect a major announcement to be forthcoming immediately (the Fed does prefer to move slowly so as not to surprise the markets), we do anticipate the Fed will reveal changes to its inflation-targeting approach, perhaps early in 2020.

 

Forecasts and projections are based on current market conditions and are subject to change without notice. Projections should not be considered a guarantee.

This article may contain assumptions that are “forward-looking statements,” which are based on certain assumptions of future events. Actual events are difficult to predict and may differ from those assumed. There can be no assurance that forward-looking statements will materialize or that actual returns or results will not be materially different from those described here.

Glossary of Terms

 Alpha is the excess return of an investment relative to the return of a benchmark index.

The Core Personal Consumption Expenditure Price Index (PCE Index) provides a measure of the prices paid by people for domestic purchases of good and service, excluding the prices of food and energy.

The break even point on a trade is when there is no gain or loss, as the current value equals the price paid.

The term premium is the compensation that investors require for bearing the risk that short-term Treasury yields do not evolve as they expected.

Indexes are unmanaged, do not reflect the deduction of fees or expenses, and are not available for direct investment.

The information provided herein is not directed at any investor or category of investors and is provided solely as general information about our products and services and to otherwise provide general investment education.  No information contained herein should be regarded as a suggestion to engage in or refrain from any investment-related course of action as Lord, Abbett & Co LLC (and its affiliates, “Lord Abbett”) is not undertaking to provide impartial investment advice, act as an impartial adviser, or give advice in a fiduciary capacity with respect to the materials presented herein.   If you are an individual retirement investor, contact your financial advisor or other non-Lord Abbett fiduciary about whether any given investment idea, strategy, product, or service described herein may be appropriate for your circumstances.

The opinions in the preceding commentary are as of the date of publication and are subject to change. Additionally, the opinions may not represent the opinions of the firm as a whole. The document is not intended for use as forecast, research or investment advice concerning any particular investment or the markets in general, and it is not intended to be legal advice or tax advice. This document is prepared based on information Lord Abbett deems reliable; however, Lord Abbett does not warrant the accuracy and completeness of the information.

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