The Fed is becoming more focused on realized inflation and growth, and should remain accommodative even if global growth turns out to be more resilient than currently believed.
- The Fed’s reaction function may be changing in subtle but important ways.
- The Fed is increasingly focused on realized inflation—concerned about the implications of slower inflation and growth abroad for the outlook in the US—and leaning into the benefits of a hotter economy and tighter labor market.
- The Fed’s evolution toward a new reaction function has been slow and halting at times.
- We expect the new reaction function will become clearer as time goes on; one way in which that may happen is that the Fed could choose to leave rates at a low level, even if global growth defies the current set of fears and remains resilient. The bottom line is that we believe future rate hikes are unlikely to be compatible with the Fed’s new emphasis.
While easy to understand, the focus on the experience of the 1990s may be a misleading guide for understanding current Fed policy. At a minimum, policy insurance is not all that is going on this year at the Fed.
The Fed’s reaction function may also be changing in subtle but important ways. The Fed is gradually shifting its framework toward average inflation targeting, which could significantly change how it will react should inflation move back up to 2%. Fed officials are increasingly vocal about the risks posed by low growth and inflation abroad. Their concern, it appears, is not only about any direct US exposure, but also about the implications of the experience abroad for the future in the US. And Fed officials, Chair Jerome Powell in particular, have started to lean in to rhetoric concerning the benefits of a hotter economy and tighter labor market.
“The emerging message is clear: Fed policy in the coming years seems quite unlikely to resemble policies of the 1990s.”
Average Inflation Targeting and the Importance of Realized Inflation
The disconnect between the labor market and inflation poses a problem for the Fed. If indeed there is no boost to inflation from a tighter labor market, or even if the boost is positive but very weak, it will be hard for the Fed to convincingly argue that inflation is set to climb higher in the near term. This in turn weighs on expectations and puts the inflation goal even further out of reach. The larger issue for the Fed, however, is that rather than being an outlier, this year is just another in a long string of disappointing inflation outcomes.
Exhibit 1: Core PCE Inflation and the Unemployment Gap
The Global Context
“The Fed is beginning to consider the experience of other central banks because it seems likely that many of the challenges they face will impact the US too, sooner or later.”
Regardless, the Fed’s concern about global conditions seems to be slightly different this year. In addition to monitoring the risks of a global slowdown, the Fed is also paying careful attention to how other central banks are navigating the current environment. The Fed is beginning to consider the experience of other central banks because it seems likely that many of the challenges they face will impact the US too, sooner or later.³ In particular, low growth and low inflation have increased the probability of nearing the lower bound in interest rates. The European Central Bank (ECB) and the Bank of Japan already have rates near the lower bound, and they are struggling to come up with appropriate responses. While US interest rates are currently above zero, there is an understandable fear that US short rates will return to zero at some point. The challenges bedeviling the Fed’s foreign counterparts have certainly registered among Fed officials and, we believe, play a role in their current decision-making.
There are at least three lessons from the experience of foreign central banks that have interest rates near the lower bound. The first is that limited efficacy of lowering policy rates means that creativity will be required to find other policies to stimulate demand. The second is that the other, creative policies will likely introduce complications, which could in turn require their own fixes. That is why the ECB has signaled that its next round of interest rate cuts will be part of a package of measures, likely including tiered interest rates and quantitative easing, in an attempt to both stimulate demand and address these other complications. The third lesson is that it is much better not to be near the lower bound, or at a minimum it’s desirable to avoid the lower bound for as long as possible.
Focusing on how foreign central banks are struggling with policy rates near the lower bound is a shift in emphasis for the Fed. It’s well established that the Fed would respond as needed should a sharp global slowdown threaten the US expansion. The Fed has done so in the past, and Fed officials regularly reassure investors about their willingness to do so again in the future, if needed. Easing policy to combat a sharp slowdown is nothing new. In contrast, it would be novel if the experience abroad—and specifically the challenge presented by the lower bound in interest rates in a foreign country—motivated the Fed to err on the side of more accommodative policy now, even in the absence of a sharp global slowdown, in order to avoid facing similar circumstances in the future.
A Renewed Focus on Growth
Powell’s speech included no indication that the US economy was near its limit on any of these dimensions. This conclusion is supported by the available labor market data. For example, the prime-age employment-to-population rate is still materially below its peak in 2000, in large part due to the still-low participation rates among prime-age men (Exhibit 2). There seems to be little if any debate that more growth, as well as more widespread growth, is among the Fed’s foremost aims right now.
Exhibit 2: Employment and Labor Force Participation
“Additional growth could also lead to a virtuous cycle of more investment and then higher productivity, which would then lead to higher neutral policy rates.”
Our view is that the Fed’s changing reaction function will become increasingly clear over time. A return to the discussion of policy insurance, which was briefly mentioned at the beginning of this note, can help illustrate one way this could potentially play out. In the near term the Fed’s actions may indeed resemble the experience of policy insurance in the 1990s. As the global growth outlook becomes better or worse, the Fed may take out more or less insurance. That much seems uncontroversial.
“Leaving rates at a lower level would be the most obvious way to meet the new goals of higher realized inflation…and boosting growth in the US.”
1 “The world in which policymakers are now operating is discretely different in important ways from the one before the Great Recession.”
– Chair Powell, Monetary Policy in the Post-Crisis Era, July 16, 2019
2 “The current era has been characterized by much lower neutral interest rates, disinflationary pressures, and slower growth. We face heightened risks of lengthy, difficult-to-escape periods in which our policy interest rate is pinned near zero. To address this new normal, we are conducting a public review of our monetary policy strategy, tools, and communications—the first of its kind for the Federal Reserve.” – Chair Powell, Challenges for Monetary Policy, August 23, 2019
3 “Average inflation rates for the other major advanced economies have declined by almost half, while the inflation rates of major emerging market economies are less than one-fifth of what they were. Indeed, with few exceptions, we are all facing lower rates of interest, growth, and inflation.” – Chair Powell, Monetary Policy in the Post-Crisis Era, July 16, 2019
The Federal Reserve Board ("Fed") is responsible for the formulation of U.S. policies designed to promote economic growth, full employment, stable prices, and a sustainable pattern of international trade and payments.
The Personal Consumption Expenditures (PCE) Price Index is a measure of price changes in consumer goods and services; the measure includes data pertaining to durables, non-durables and services. This index takes consumers' changing consumption due to prices into account, whereas the Consumer Price Index uses a fixed basket of goods with weightings that do not change over time. Core PCE excludes food & energy prices.
The unemployment gap is defined as the difference between the nonaccelerating inflation rate of unemployment and the actual unemployment rate.
Forecasts are inherently limited and should not be relied upon as indicators of actual or future performance.
All investments involve risk, including possible loss of principal.
The value of investments and the income from them can go down as well as up and investors may not get back the amounts originally invested, and can be affected by changes in interest rates, in exchange rates, general market conditions, political, social and economic developments and other variable factors. Investment involves risks including but not limited to, possible delays in payments and loss of income or capital. Neither Legg Mason nor any of its affiliates guarantees any rate of return or the return of capital invested.
Equity securities are subject to price fluctuation and possible loss of principal. Fixed-income securities involve interest rate, credit, inflation and reinvestment risks; and possible loss of principal. As interest rates rise, the value of fixed income securities falls.
International investments are subject to special risks including currency fluctuations, social, economic and political uncertainties, which could increase volatility. These risks are magnified in emerging markets.
Commodities and currencies contain heightened risk that include market, political, regulatory, and natural conditions and may not be suitable for all investors.
Past performance is no guarantee of future results. Please note that an investor cannot invest directly in an index. Unmanaged index returns do not reflect any fees, expenses or sales charges.
The opinions and views expressed herein are not intended to be relied upon as a prediction or forecast of actual future events or performance, guarantee of future results, recommendations or advice. Statements made in this material are not intended as buy or sell recommendations of any securities. Forward-looking statements are subject to uncertainties that could cause actual developments and results to differ materially from the expectations expressed. This information has been prepared from sources believed reliable but the accuracy and completeness of the information cannot be guaranteed. Information and opinions expressed by either Legg Mason or its affiliates are current as at the date indicated, are subject to change without notice, and do not take into account the particular investment objectives, financial situation or needs of individual investors.
The information in this material is confidential and proprietary and may not be used other than by the intended user. Neither Legg Mason or its affiliates or any of their officer or employee of Legg Mason accepts any liability whatsoever for any loss arising from any use of this material or its contents. This material may not be reproduced, distributed or published without prior written permission from Legg Mason. Distribution of this material may be restricted in certain jurisdictions. Any persons coming into possession of this material should seek advice for details of, and observe such restrictions (if any).
This material may have been prepared by an advisor or entity affiliated with an entity mentioned below through common control and ownership by Legg Mason, Inc. Unless otherwise noted the "$" (dollar sign) represents U.S. Dollars.
This material is only for distribution in those countries and to those recipients listed.
All investors and eligible counterparties in EU and EEA countries:
In Europe (excluding UK and Switzerland), this financial promotion is issued by Legg Mason Investments (Ireland) Limited, registered office Floor 6, Building Three, Number One, Ballsbridge, 126 Pembroke Road, Ballsbridge, Dublin 4. D04 EP27, Ireland. Registered in Ireland, Company No. 271887. Authorised and regulated by the Central Bank of Ireland.
In the UK, this financial promotion is issued by Legg Mason Investments (Europe) Limited, registered office 201 Bishopsgate, London EC2M 3AB. Registered in England and Wales, Company No. 1732037. Authorized and regulated by the UK Financial Conduct Authority.
In Switzerland, this financial promotion is issued by Legg Mason Investments (Switzerland) GmbH, authorised by the Swiss Financial Market Supervisory Authority FINMA.
Investors in Switzerland: The representative in Switzerland is FIRST INDEPENDENT FUND SERVICES LTD., Klausstrasse 33, 8008 Zurich, Switzerland and the paying agent in Switzerland is NPB Neue Privat Bank AG, Limmatquai 1, 8024 Zurich, Switzerland. Copies of the Articles of Association, the Prospectus, the Key Investor Information documents and the annual and semi-annual reports of the Company may be obtained free of charge from the representative in Switzerland.
All Investors in Hong Kong and Singapore:
This material is provided by Legg Mason Asset Management Hong Kong Limited in Hong Kong and Legg Mason Asset Management Singapore Pte. Limited (Registration Number (UEN): 200007942R) in Singapore.
This material has not been reviewed by any regulatory authority in Hong Kong or Singapore.
All Investors in the People’s Republic of China (“PRC”):
This material is provided by Legg Mason Asset Management Hong Kong Limited to intended recipients in the PRC. The content of this document is only for Press or the PRC investors investing in the QDII Product offered by PRC’s commercial bank in accordance with the regulation of China Banking Regulatory Commission. Investors should read the offering document prior to any subscription. Please seek advice from PRC’s commercial banks and/or other professional advisors, if necessary. Please note that Legg Mason and its affiliates are the Managers of the offshore funds invested by QDII Products only. Legg Mason and its affiliates are not authorized by any regulatory authority to conduct business or investment activities in China.
This material has not been reviewed by any regulatory authority in the PRC.
Distributors and existing investors in Korea and Distributors in Taiwan:
This material is provided by Legg Mason Asset Management Hong Kong Limited to eligible recipients in Korea and by Legg Mason Investments (Taiwan) Limited (Registration Number: (98) Jin Guan Tou Gu Xin Zi Di 001; Address: Suite E, 55F, Taipei 101 Tower, 7, Xin Yi Road, Section 5, Taipei 110, Taiwan, R.O.C.; Tel: (886) 2-8722 1666) in Taiwan. Legg Mason Investments (Taiwan) Limited operates and manages its business independently.
This material has not been reviewed by any regulatory authority in Korea or Taiwan.
All Investors in the Americas:
This material is provided by Legg Mason Investor Services LLC, a U.S. registered Broker-Dealer, which includes Legg Mason Americas International. Legg Mason Investor Services, LLC, Member FINRA/SIPC, and all entities mentioned are subsidiaries of Legg Mason, Inc.
All Investors in Australia:
This material is issued by Legg Mason Asset Management Australia Limited (ABN 76 004 835 839, AFSL 204827) ("Legg Mason"). The contents are proprietary and confidential and intended solely for the use of Legg Mason and the clients or prospective clients to whom it has been delivered. It is not to be reproduced or distributed to any other person except to the client's professional advisers.