Jerome Powell has announced sweeping changes to the Federal Reserve’s Statement on Longer-Run Goals and Monetary Policy Strategy, encompassing a significantly more dovish reaction function for the world’s most important central bank.
With the adoption of average inflation targeting and a move away from maximum employment as a prime influence on policy, Jerome Powell has signalled a seismic change in the Federal Reserve’s monetary policy strategy. When combined, the two changes add up to a significantly more dovish reaction function from the Fed, which is now far less likely to engage in preemptive rate hikes in response to anticipated increases in inflation.
Average inflation targeting is the less significant of today’s two major changes from the Fed, as it is really just a formalization of what has been the consensus on the FOMC for some time.
This change seems aimed at making it clear that the Fed will not be overly concerned with temporary spikes in inflation above target.
The most significant change today is likely to be the move away from maximum employment as a policy variable.
Although the change in the statement is subtle, merely saying the Fed will consider “shortfalls” from maximum employment as opposed to “deviations”. However, in his speech, Powell explained the significance of the change. Whereas previously, the Fed would be willing to hike interest rates as the labour market approached estimates of maximum employment, Powell has made it clear that uncertainty around these estimates mean that they will not be relied upon as much in the future. Instead, Powell stated “employment can run at or above real-time estimates of its maximum level without causing concern, unless accompanied by signs of unwanted increases in inflation”. This is a clear break with prevailing policy wisdom going back as far as the 1980s – its significance is difficult to overstate.
The United States economy was one of the outperformers of the 2010s, and the dollar saw several cycles of strength, for example in 2015 and 2016, as markets correctly anticipated monetary policy tightening cycles from the Fed. These hiking cycles were based on estimates of rising employment as opposed to actual signs of inflation accelerating. Under the Fed’s new regime, even once the US economy begins to recover, markets will have far less reason to expect higher rates in the US. As such, we are likely to see a far less responsive US dollar to any possible economic upswing.
Good-bye to rate hikes: USD and the Federal Funds rate
Author: Ranko Berich, Head of Market Analysis