Multi-Asset

The Fed’s new framework and its evolving reaction function

For investors, the implications are likely to be a more durable long-run “risk on” environment, a flatter yield curve and a depreciating dollar.
October 2020

Amid an accelerating election season, ongoing pandemic and a return to partisan gridlock, the Federal Reserve (Fed) has been a bit less prominent in the news cycle lately. However, at the central bank’s annual August retreat in Jackson Hole, Chairman Jerome Powell announced amendments to the Fed’s Statement on Longer-Run Goals and Monetary Policy Strategy, which had been largely unchanged since 2012. At a recent mini-forum on this topic, we discussed the significance of this change and its implications for future Fed policy and for investors.

How did we get here?

For some perspective on this policy change, it is helpful to take a quick look back at the monetary policy environment of early 2019. From his predecessor Janet Yellen, Chairman Powell inherited a Federal Open Market Committee (FOMC) clearly tightening through higher rates and shrinking the balance sheet, policies the Powell Fed initially continued through 2018. However, many at the Fed had noticed sufficient changes in several structural features of the economy to call into question their near-term hawkish policy path and longer-run framework. First, the general level of interest rates had fallen close enough to zero to limit the ability of the FOMC to significantly reduce their policy rate in response to negative economic shocks. Second, inflation had consistently fallen short of the Fed’s own 2% target for an extended period.

PCE core inflation versus Fed target, 2012 – 2020

The Feds new framework and its evolving reaction function - PCE core inflation versus Fed target 2012-2020 - chart image

Source: U.S. Bureau of Economic Analysis, U.S. Federal Reserve.

Third, the level of unemployment consistent with the Fed’s mandate of full employment fell persistently after the financial crisis of 2008. Finally, the responsiveness of inflation to that level of unemployment had seemingly disappeared. A comprehensive review of the FOMC’s monetary policy framework was launched as a result. Taking a more dovish approach immediately, however, was complicated by the Fed’s tradition of incremental change and President Trump’s incursions into the usually politically neutral arena of monetary policy. In an effort to distance itself from this politicization, the Fed likely eased more slowly than perhaps Powell and others would have preferred, at least until COVID-19 cleared the way for dramatic interest rate cuts and aggressive expansion of the Fed’s balance sheet in 2020.

The Phillips curve is dead

With stubbornly low inflation tormenting the Fed during the Yellen years and into Powell’s tenure, it is not surprising that the principal element of the new policy featured in August was the targeting of an average rate of inflation over time, not a specific threshold value. The change to the Fed’s approach to unemployment, however, is just as important and deserves more attention. The Fed has effectively declared the Phillips curve dead, though it will still forecast the inputs. Going forward, policy decisions will be asymmetric, made according to shortfalls from maximum employment rather than a specific employment metric. Most tellingly, the Fed has been deliberately vague about what “maximum employment” means, underscoring the uncertainty around forecasting in today’s environment. This is an evolution of the Fed’s approach under Yellen, which was influenced by her background as a labor economist. In the years following the financial crisis, the Fed kept the faith that wages would rise at some point during the recovery as labor markets tightened, driving broader inflation higher. But as unemployment dropped steadily in the decade following the crisis, inflation failed to consistently push higher, countering the Phillips curve’s assumption of an inverse relationship between unemployment and inflation. In its new framework, the Fed has greater latitude to let the economy run hotter, leading some to quip that Powell has become “Yellen on steroids.”

PCE core inflation and unemployment in the 2010s

The Feds new framework and its evolving reaction function - PCE core inflation and unemployment in the 2010s - chart image

Source: U.S. Bureau of Labor Statistics.

Powell differs from his predecessor in terms of inflation: the Yellen Fed tolerated inflation overshoots, but would not engineer them. Now, the Fed promises symmetry in future inflation around the 2% average target, but it has yet to be tested in real-world inflationary conditions. That inflation test should eventually come, given the Fed’s significant formal commitment to running the economy as hot as it possibly can until the price level accelerates.

The fork in the road

The Fed now faces a transition from recession-induced support to policy that reflects concerns about sustained low inflation, rates and growth. Although rates are low, asset purchases have continued and plenty of capacity remains in the liquidity and lending programs launched following COVID-19; Chairman Powell has continuously called for additional fiscal support from Congress. This makes the upcoming election vital to the policy mix. If President Trump wins and Republicans maintain their Senate majority, the result is likely to keep inflation at low levels. Republican skepticism regarding more fiscal stimulus will probably continue, barring another dramatic downturn in economic data during Trump’s second term. The status quo will likely render a similar outcome, with partisan gridlock keeping further stimulus under wraps and the U.S. economy undergoing a slow and uneven recovery.

If we see a Democratic majority in the Senate combined with a Biden win, fiscal policy is likely to be aggressive from day one, with infrastructure, education, child care and job training among the initiatives likely to be launched. The Fed will remain dovish as they believe these policies may help the economy reach the Fed’s twin mandates of maximum sustainable employment and price stability. The deficit, however, will expand further and inflation expectations may also rise, testing the Fed’s belief that expectations drive inflation more than the Phillips curve. The Fed may be pleased to take a backseat to fiscal policy, but higher inflation could bring the focus back to monetary policy. Though it seems unlikely today, a scenario with accelerating inflation and heavy debt burdens on government and households could require the kind of tough decision-making that Paul Volcker brought to the Fed in the late 1970s. While this would be a dramatic change from the current environment, the Fed has promised to remain adaptable in the short term, and its policy framework is reviewable every five years should a more significant course change become necessary in the future.

Implications for investors

The phrase “lower for longer” may seem headed for the discard pile with the Phillips curve. Some have joked that it should be replaced with “low rates forever.” For investors, the implications are likely to be a more durable long-run “risk on” environment, a flatter yield curve and a depreciating dollar. Asset bubbles may occur more frequently in this environment and contribute to greater volatility. However, the Fed’s new framework will only truly be tested later in the cycle when employment conditions tighten and the central bank must use this new policy framework and tools to contain inflation.

Subscribe to our insights

Disclosures

This is not intended to serve as a complete analysis of every material fact regarding any company, industry or security. The opinions expressed here reflect our judgment at this date and are subject to change. Information has been obtained from sources we consider to be reliable, but we cannot guarantee the accuracy. This presentation may contain forward-looking statements. “Forward-looking statements,” can be identified by the use of forward-looking terminology such as “may”, “should”, “expect”, “anticipate”, “outlook”, “project”, “estimate”, “intend”, “continue” or “believe” or the negatives thereof, or variations thereon, or other comparable terminology. Investors are cautioned not to place undue reliance on such statements, as actual results could differ materially due to various risks and uncertainties. This publication is prepared for general information only. This material does not constitute investment, tax or legal advice to any party and is not intended as an endorsement of any specific investment. It does not have regard to the specific investment objectives, financial situation and the particular needs of any specific person who may receive this report. Investors should seek advice regarding the appropriateness of investing in any securities or investment strategies discussed or recommended in this report and should understand that statements regarding future prospects may not be realized. Investment involves risk. Market conditions and trends will fluctuate. The value of an investment as well as income associated with investments may rise or fall. Accordingly, investors may receive back less than originally invested.

Foreign investing involves special risks due to factors such as increased volatility, currency fluctuation and political uncertainties. Investing in emerging markets can be riskier than investing in well-established foreign markets.

Past performance is not necessarily a guide to future performance. Asset allocation does not ensure a profit or guarantee against loss.

In the United States and Canada, BMO Global Asset Management is the brand name for various affiliated entities of BMO Financial Group that provide investment management and trust and custody services. Certain of the products and services offered under the brand name BMO Global Asset Management are designed specifically for various categories of investors in a number of different countries and regions and may not be available to all investors. Products and services are only offered to such investors in those countries and regions in accordance with applicable laws and regulations. BMO Financial Group is a service mark of Bank of Montreal (BMO).

BMO Asset Management Corp., BMO Private Bank, BMO Harris Bank N.A. and BMO Harris Financial Advisors, Inc. are affiliated companies. BMO Private Bank is a brand name used in the United States by BMO Harris Bank N.A. BMO Harris Financial Advisors, Inc. is a member FINRA/SIPC, an SEC registered investment adviser and offers advisory services and insurance products. Not all products and services are available in every state and/or location.

This financial promotion is issued for marketing and information purposes; in the United Kingdom by BMO Asset Management Limited, which is authorised and regulated by the Financial Conduct Authority; in the EU by BMO Asset Management Netherlands B.V., which is regulated by the Dutch Authority for the Financial Markets (AFM); and in Switzerland by BMO Global Asset Management (Swiss) GmbH acting as representative offices of BMO Asset Management Limited in Switzerland, which are authorised by FINMA.

Securities, investment advisory and insurance products are: NOT A DEPOSIT — NOT FDIC INSURED — NOT BANK GUARANTEED — MAY LOSE VALUE.

© 2020 BMO Financial Corp.

Related articles

No posts matching your criteria

The ESG implications of COVID-19: Annual General Meetings (AGMs)

Discover how COVID-19 has pushed AGMs around the world into an online format.

The ESG implications of COVID-19: Executive Pay

Explore the executive pay implications of COVID-19 at top UK companies

BMO SDG Engagement Global Equity Strategy Impact Report 2020

In this report, we carry out a deep dive into our engagement activities, showing the alignment to the SDGs and their targets.

ESG Viewpoint – COVID-19 and the pharmaceutical industry

How is the pharmaceutical industry responding to COVID-19?

Investor engagement: lessons from the Global Financial Crisis

How did the global financial crisis shape investor engagement?

Investor engagement: routes to escalation

Discover investor engagement escalation strategies.

The future of investor engagement

Discover what we believe will shape investor engagement this decade.

Investor engagement: crossing boundaries

Discover how investor engagement is crossing boundaries.

Investor engagement: Case studies

Discover three investor engagement case studies