The Fed has managed to do a lot of things through its fiscal stimulus policies of the past year.
It saved the overnight repo market from a massive liquidity crunch. It did a rapid about-face on interest rate policy that saved the S&P 500 from a 20% loss in the 4th quarter of 2018. It's provided trillions of dollars of stimulus to help the U.S. economy deal with the COVID-19 pandemic. It dropped the target Fed Funds rate all the way to 0%.
There's one thing, however, that it hasn't been able to do. It can't get the inflation rate up to its 2% target.
The Fed has long stated that it's goal is to maximize employment while keeping inflation modest, but its preferred indicator - the Personal Consumption Expenditures Index - has failed to get anywhere near that area with any consistency.
The pre-financial crisis years were really the last time the PCE index got to and stayed above the 2% level. The housing bubble killed that and the index has struggled to get above that level ever since.
The more commonly cited inflation and core inflation rates have been somewhat higher, but they've noticeably declined during the coronavirus outbreak.
With the inflation rate running persistently below the 2% target, the Fed may be preparing for a monumental shift its strategy.
Back at the end of 2019, it was rumored that the Fed was considering moving away from an "inflation rate target" to an "average inflation rate target". What does that mean? In short, the central bank would be willing to let the inflation rate run above its target for a period of time to account for the period of time where it ran under the target.
For example, if the inflation rate was 1% for a two-year period, the Fed would be OK with an inflation rate at 3% for two years in order to achieve an average 2% target.
Now, we're hearing that the Fed could officially announce this strategy as early as the September quarterly FOMC meeting.
What High Inflation Would Look Like
We know that the COVID-19 outbreak has put the economy far away from its dual mandate of maximum employment and controlled inflation.
The unemployment rate was 11.1% in June, a far cry from the 3.5% rate it bottomed out at less than a year ago. The latest PCE index reading came in at 0.75%, again, well below the 2% target.
It's not exactly the best time to try increasing the cost of living when so many people are out of work and potentially losing their homes, but that's a discussion for another day. But the Fed appears ready to take that step.
The initial indication that the Fed was considering this path came back in December 2019, but it was reiterated recently by Philly Fed President Patrick Harker.
In the article, Harker says:
“I’m supportive of the idea of letting inflation get above 2% before we take any action with respect to the federal funds rate.”
Lael Brainard is also on board.
On Tuesday, Fed Governor Lael Brainard also backed the idea of letting inflation get over 2% before the Fed takes any action to raise interest rates. This promise is called “forward guidance” at the central bank. Typically, the Fed would hike rates preemptively if it saw inflation surging.
If this is indeed the Fed's plan, considering the fact that the Fed's preferred inflation measure hasn't consistently been above its target in more than a decade, it could be years before we see an interest rate hike again.
High Inflation Expectations Already Showing Up In Asset Prices
The Fed has already done about as much as it can to fire up inflation. Its COVID stimulus package is already over $3 trillion. If Congress ever negotiates an extension of the unemployment benefits package, the next round could cost between $1 trillion and $3 trillion, depending on the composition of the bill.
The target Fed Funds rate is already at 0%. There have been talks of interest rate caps as well. Outside of taking interest rates into negative territory or continuing to flood the marketplace with cheap dollars, there really isn't much more the Fed can do, despite its insistence that it has plenty of weapons left.
Investors, on the other hand, have been doing something.
Net fund flows show that they've been piling into Treasury Inflation-Protected Securities (TIPS) in large quantities lately. In fact, TIPS have been steadily outperforming intermediate-term Treasuries for more than 4 straight months.
Higher inflation expectations are also showing up in precious metals prices.
And they're showing up in the value of the dollar.
The breakeven inflation rate is still only sitting at around 1.4%, so overall expectations are still pretty low. Inflation-sensitive asset prices, however, are already pricing in higher inflation rates.
Where Do Asset Prices Go From Here?
Everything the Fed has done to this point is eventually going to cause two things - a weakening dollar and higher inflation.
All of the money that the Fed has flooded the market with (and is likely to continue flooding the market with) will almost certainly devalue the greenback. This is economics 101. When there's an oversupply of something, the inherent value of it goes down and demand probably decreases as well.
That's a good thing for foreign assets, including international stocks & bonds as well as companies with a greater global presence. I've been a believer in emerging markets stocks for some time and this narrative plays right into that hand.
Higher inflation is almost certain to arrive eventually. With thousands of dollars in stimulus cash, record low borrowing rates and retail sales already back to pre-COVID levels, it's just a matter of time before it shows up in consumer prices. Plus, with the inflation and core inflation rates consistently measuring higher than the PCE rate, common inflation measures could get to 3-4% easily before the Fed even thinks about doing something about it.
That's a perfect scenario for TIPS, which are indexed to inflation and would rise in value as inflation rises.
The table has been fully set for a rising inflation environment. Rates are low, consumers have cash, the economy is flooded with cheap dollars. It just needs to show up in prices.
With the Fed so gun shy about raising rates given how things turned out in 2018, I'd expect Powell and company to let inflation run well above the 2% target before even thinking about a rate hike. If the Fed is truly going to switch to an average inflation target model, I wouldn't be entirely surprised to see the inflation rate exceed 4% in the near future.
Get ready! The Fed is all set to let inflation run wild on this economy!
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