What said Fed
After announcing a historic shift in monetary policy in August, the Federal Reserve doubled down on its ultra-accommodative stance, surprising no one by holding interest rates near zero during its latest meeting on September 16. The Fed pledged to keep rates anchored at the current level until inflation rises persistently, with projections indicating rates could remain near zero through 2023.1
The big-ticket item for this meeting was whether the Fed would provide more specifics about the new “average inflation targeting” approach it debuted at its annual symposium late last month. This policy shift signaled a major departure from how the central bank has steered the economy in the past, and offered clues about how it may guide prices and the labor market going forward.
The Fed's new framework
Following a year-long review, the Federal Reserve announced on August 27 that it would adopt a new framework for managing inflation—average inflation targeting, which allows inflation to exceed the Fed’s 2% goal for some time following periods of persistently low inflation (such as the past 10 years). Also, the Fed tweaked its statement on long-term employment goals, reinforcing its commitment to achieving maximum employment and its position that a strong job market can be sustained without causing rampant inflation.2
Where do inflation and employment currently stand?
Inflation (the overall price of goods and services in an economy) has been running below the Fed’s 2% target for the better part of the last decade. Although consumers generally welcome low prices, inflation that is too low can actually weaken an economy by driving future expectations for prices, and interest rates, even lower.
While inflation is currently low, the longer-term concern is that it won’t stay that way in the face of the unprecedented monetary and fiscal stimulus that’s been unleashed to fight the coronavirus. But with its new policy, the Fed appears comfortable with inflation overshooting its traditional 2% target, and would hold back on hiking interest rates as long as larger economic needs were being served.
The Fed’s other mandate is full employment. After peaking at 14.7% in April during the height of lockdown, the unemployment rate has steadily declined. The latest jobs report showed continued improvement in labor market gains, with unemployment dropping from 10.2% to 8.4%. The central bank updated its economic projections at its latest meeting, forecasting unemployment would continue to decline to 7.6% by year-end.1
The Fed has traditionally viewed a tight labor market as a potential inflation driver, but as the chart above shows, even during periods of historically low unemployment, inflation remained well below 2%. The implication is that the Fed may now stand pat on rates even if the employment outlook continues to improve, and unemployment falls below a threshold that in the past would have triggered a rate hike.
While Fed officials didn’t define specific thresholds for inflation and unemployment that would warrant raising interest rates, they did revise their post-meeting statement to emphasize their goal of achieving inflation above 2% for some time before altering their policy, with Chairman Powell stating “these changes clarify our strong commitment over a longer time horizon.”1
Here are a few things for investors to keep in mind amid the current environment:
- Be cautious in the search for yield: The temptation to hunt for yield opportunities may be growing, but be wary of chasing income in the riskiest parts of the market. Do your homework on a stock’s potential to grow earnings and dividends over the long term or a bond issuer’s ability to make ongoing interest payments. Consider a total return approach to investing—appreciation is just as important as income.
- Low rates can be a double-edged sword: A low-rate environment can help fuel a bull market, but it can also overheat it, making stocks susceptible to sharp corrections, especially in a fragile economic environment.
- Keep an eye on the dollar: The US dollar has been weakening since early this year after a fairly long period of appreciation. Although it’s currently off its lows, many analysts think it could continue to weaken, contributing to a run-up in inflation. If that happens, investors may want to consider diversifying into assets that tend to perform well during periods of rising inflation, such as real estate and commodities.
The Federal Open Market Committee is next scheduled to meet November 4–5. Remember to stay the course and keep investing decisions focused on individual timelines, long-term goals, and risk tolerance.
- CNBC, “Fed holds rates steady near zero and indicates it will stay there for years,” 9/16/20, https://www.cnbc.com/2020/09/16/fed-meeting-decision-interest-rates.html
- CNBC, “Powell announces new Fed approach to inflation that could keep rates lower for longer,” 8/27/20, https://www.cnbc.com/2020/08/27/powell-announces-new-fed-approach-to-inflation-that-could-keep-rates-lower-for-longer.html