Over the last year we have written at length about prevailing market narratives and their remarkable ability to shift quickly. As 2019 began, investors took another 180 degree turn in thinking, in a manner similar to one we have encountered frequently over the past decade. On several occasions since the crisis, investors have grown concerned about slowing growth, weak inflation and the risks of overly restrictive monetary policy. Through these bouts of anxiety, central banks have relieved the tension, providing the necessary accommodation and effectively extending the economic expansion. Fear of recession was in full bloom in the fourth quarter of 2018, but again central banks (and particularly the Federal Reserve), abandoned plans for reducing accommodation and switched to a
more dovish policy stance.
Still, we advise against interpreting the shift in the US monetary policy stance as a standard reaction to downside growth risks. Under the surface, there has been a significant shift in how US policymakers are thinking about inflation and managing the later stages of this expansion, with meaningful implications for markets. The shift will impact not just the policy stance this year but, importantly, the Committee’s reaction function over the longer run. Specifically, having on numerous occasions incorrectly projected higher inflation, the Committee has shifted into wait-and-see mode, and will now prove unwilling to raise rates going forward absent irrefutable evidence of firming inflation. Quite simply, taking policy into restrictive territory while the Committee has missed its inflation objective for the past decade would risk a policy error that could have consequences for the central bank’s independence and its degrees of freedom to navigate the next recession.
While the above thinking represents a tactical shift, a strategic shift is under way as well. The Committee is well aware that structurally low interest rates will make achieving the employment and price stability mandate even more challenging in the next recession, because there will be limited space to take the real policy rate far below a depressed setting of the neutral rate. In such an environment, a central bank can build up extra ammunition for the next recession by boosting inflation and inflation expectations ahead of time. With this goal in mind, next year we expect the Committee to formally shift its policy strategy away from flexible inflation targeting to average inflation targeting, with the implication that the Committee will seek to sustain average core inflation above two percent for the remainder of this expansion. Such a change represents an unambiguous dovish shift in the Federal Reserve’s reaction function. With such a shift on the horizon, tightening policy in the meantime is largely off the table – higher inflation, if it were to occur, is not just to be tolerated, but encouraged. And indeed, come next year and the formal change in framework, any disinflation could lead to modest rate cuts even if growth remains around trend.