Those With Inflated Expectations for Fed Talk May Be Let Down

The Federal Reserve on Wednesday held its first Open Market Committee meeting since adopting an average inflation targeting (AIT) regimen. So far, Fed Chair Jerome Powell has only given us broad strokes of how AIT would be implemented. This was his first chance to get more specific -- both about what AIT means for current policy, as well as how the Fed will interpret incoming data down the road. I'd argue that how AIT is executed will be the single most important item for investment markets over the next five years. Here's what we learned from this meeting as well as my thoughts on lingering questions. No New Guidance, No New Stimulus In terms of actual actions by the Fed, we got ... pretty much nothing. Now that the Fed has announced AIT, additional forward guidance is mostly superfluous. If the Fed sticks to this new framework, we know it won't be hiking rates until core inflation gets meaningfully above 2%. It went ahead and said as much in the post-meeting statement: the Committee will aim to achieve inflation moderately above 2% for some time.... I suppose there's value in reiterating it, but the point is now a given under an AIT framework. My belief is that the Fed can indeed engineer the inflation it wants, but it needs to be patient. Only once the labor market gets hot again are we likely to see inflation creep up. That probably means no rate hikes until unemployment falls from the current 8.4% to something close to 4%. It likely also requires the roughly 4 million people who left the labor force since January to return. All that is going to take time, likely multiple years at the least. Indeed, the Fed's dot plot shows almost no members thinking rates are going to rise in the next three years. Not Much in the Toolbox Now that the Fed has announced IAT, many reasonably expected it to also announce some new tactics to actually push inflation higher. At least at this meeting, none were forthcoming. Not only did the Fed not announce any change in its current quantitative easing purchases, Powell downplayed QE in his post-meeting press conference. He essentially said that while the Fed would be flexible with QE purchases, forward rate guidance was doing all the heavy lifting in terms of stimulus. This is a tacit admission that QE is a tool for restoring market liquidity, but doesn't really work well as a stimulus measure. As far as other new stimulus, the Fed has very limited options. They've already tabled an idea like yield curve control, correctly assessing this tool would have limited impact with rates already so low. Similarly, other credit market tools, such as stepping up purchases of corporate bonds, have the same problem. Lowering the cost of borrowing by 10 or 20 basis points for big companies isn't likely to result in substantially more money in the hands of end consumers. Consumer spending is obviously the ultimate driver of inflation. Other tools the Fed could use are all hypothetical. An idea like helicopter money is too radical for the Fed to actually consider near-term. But even less radical ideas, such as a funds for lending program, similar to the Bank of England's, haven't gotten any serious discussion at FOMC meetings yet. Such programs would take time to vet within the committee, time to design, and finally time to put into operation. I'd be surprised if there were any truly new Fed stimulus programs anytime this calendar year. How Long Will 'Some Time' Be? Many economists came into this meeting hoping for some more specificity for how AIT would work. How long a period would average be measured? How far back would the Fed look to determine the degree of short-fall when inflation ran below 2%? How long would it give itself to catch up to get average inflation back above 2%? Powell was firm that the Fed isn't going to create a hard rule. While academics may debate whether a rule would be better or not, given how forceful Powell was on this issue, I think this puts the matter to bed for now. The Fed will loosely follow an AIT framework, but there will still be a good bit of discretion. Rosie Forecast, Rates Unchanged The Fed also released its Summary of Economic Projections this meeting. It raised its estimate for 2020 GDP from -7.6 to -5.5% to -4.0% to -3.0%. The group also sees unemployment getting to 4% in 2023. But it is notable that even with an improved outlook from the committee, virtually no members are interested in raising rates. Seems like the buy-in is strong for average inflation targeting. Market Reaction, Investment Ideas The market reaction was generally muted, suggesting the Fed pretty much delivered on what the market expected. But I think the yield curve steepening and the Treasury Inflation-Protected Securities (TIPS) break-evens widening (suggesting more long-run inflation) are both signs this release was viewed as mostly dovish. We also may be getting some cross-currents. The mortgage bond market is acting like it expected more QE. Perhaps stock traders thought the same, and that's why stocks are falling from their highs a bit. On the other hand, Chairman Powell was resolute in his commitment to see inflation rise. That and the uniformity in the dot plot were both more dovish signs. I think the right trade is to bet on the yield curve continuing to steepen. It is extremely unlikely that the Fed would hike rates within the next two to three years, and it could be much longer. But the bond market won't wait until the day to reprice rates out the curve. This means that once rates do start rising, it will be led by longer rates. We're quite underweight 10-30 year bonds now anticipating that the longest bonds will be the first sign of a recovering economy. High to medium quality corporate bonds are also very attractive here. I know spreads are far tighter than they were in March, but in general BBB-rated bonds are still wider than pre-Covid. If you stick with companies that have a lot of balance sheet flexibility, time is on your side as you collect the extra yield. If the economy does improve, you will get some price appreciation as spreads fall. TIPS are OK, but I like corporate bonds much better. A 10-year TIPS position now has priced in about 1.7% inflation. If the Fed is successful, inflation will average 2.0%. So you made a whopping 0.3% extra? If you assume inflation only rises in a scenario where the economy is improving, corporate bonds have much more upside and earn you more yield while you wait.

Those With Inflated Expectations for Fed Talk May Be Let Down

The Fed gives few new clues on how it will handle the average inflation targeting program; here's my read on the meeting.

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