The Federal Reserve Bank Chairman announced a change in interest rate policy last week. The new policy's new goal is that “following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time.”
What does this mean? First, we should look at the Federal Reserve Bank's (FRB) goals: "The Federal Reserve works to promote a strong U.S. economy. Specifically, the Congress has assigned the Fed to conduct the nation’s monetary policy to support the goals of maximum employment, stable prices, and moderate long-term interest rates. When prices are stable, long-term interest rates remain at moderate levels, so the goals of price stability and moderate long-term interest rates go together. As a result, the goals of maximum employment and stable prices are often referred to as the Fed’s “dual mandate.”
With the knowledge that the FRB's goals are full employment and stable prices, we need to understand how the Federal Reserve Bank (FRB) has acted to 'achieve stable prices' - keep inflation low - by slowing economic activity when inflation rates rise using interest rate ‘policy’. The three powers historically used by the FRB to affect that change are;
- raising the Federal Funds Rate (the average rate at which banks loan to each other uncollateralized through FRB targeting),
- raising the Discount Rate (the rate at which the FRB directly loans cash to commercial and retail banks), and
- ‘Moral Suasion’ (announcing to the market its concerns and intentions should it need to 'act').
As shown in the chart below, The Fed has used 2% inflation as the definition of 'stable prices' and moved the Fed Funds Rate aggressively when inflation accelerated and looked to be headed above 2%, or rapidly dropped the rate due to recession, until 2008:
In 2008, to fight the Great Recession (2007-09), the FRB added another tool called Quantitative Easing (QE), in which they openly purchased US Treasury Bills, Notes, and Bonds and some mortgage-backed securities directly from the market through Open Market Operations (OMO) to hold on their balance sheet – this effectively lowered interest rates (by reducing the supply of bonds), put money into circulation and forced investors to increase their risk levels in search of investment return. Even after the recovery, inflation has remained relatively subdued and the Fed Funds rate low. During the Covid Pandemic the FRB extended it's QE policy to buying virtually all types of debt both directly and through the purchase of mutual and exchange-traded funds.
The change in Federal Reserve Policy to let inflation run moderately above 2% for an extended period of time AFTER it has been persistently below 2% for an extended period means that they are unlikely to use the tools at their disposal to slow economic activity unless they see acceleration above the 2% level that they believe could be troublesome. They will let economic activity accelerate even if it means somewhat higher inflation.
How likely is that? As we have discussed previously, inventories are very low and home building is going to accelerate, and that could lead to commodity and labor shortages, which would increase costs.
Yet, for the last 25 years, we have seen inflation trending flat to lower even during the mid-1990s through early-2000s housing boom and stock market highs as shown in Chart 1 below.
It would seem to appear that the homebuilding boom that peaked in 2006 and is likely to accelerate again, along with a rising stock market – or supply and demand, that should be contributors to inflation has not been, at least to the extent that they were historically.
We believe that the increasing rate of technology transformation and its near-immediate use is going to keep inflation relatively subdued. The increased use of technology in location, extraction, and transportation of raw materials and commodities will likely keep those costs low. We also believe that the continued acceptance of new forms of technology by people in our daily lives has created a de facto continuous training cycle. This continuous training cycle allows businesses to plug people into new roles productively almost immediately upon hiring versus the training periods just a decade or two ago.
That does not mean there is no risk from rising ‘rates’, but that risk may have to do with the massive supply of debt that has been created in the last decade and is likely to continue. In the chart below we see that not only has the US Government nearly quadrupled the debt in the last two decades but that US Corporate debt has done so as well.
Therefore, the FRB may end up in a position that to keep rates low it has to continue to ‘buy’ an ever-increasing supply of debt, and there may be limits to what the market perceives as ‘credible’ policy. We certainly are not 'there' yet, but as with many things, it might be that it happens very slowly, and then all at once.