The Fed's Policy Review

My Prediction

The new framework for the next five years of monetary policy is expected to be revealed today during Fed Chairman Powell’s speech in Jackson Hole. The Fed reviews its policy every five years, based upon underlying principles stated back in 2012.

They call the current framework “Flexible Average Inflation Targeting” (FAIT), and it sets an asymmetric mean inflation target at 2%, with no specified time frame for calculating the mean. It is asymmetric with regard to a tolerance for temporary inflation rates above 2% to help counter zero lower bound concerns and allow for some extent of price level targeting. This was apparently in response to what the Fed effectively acknowledges as anemic monetary stimulus during the Great Recession and its slow recovery. The Fed was apparently relying heavily on non-market internal forecasts that consistently overestimated future inflation rates.

The Fed allowed inflation to run too hot for too long during the pandemic recovery however, apparently fighting the last war. This lead to the highest inflation rates since the 1970s and above target inflation that continues today.

I have no special information about the new policy to be announced today, but I do have an impression that this Fed operates with rationality, though limited. So, I think they will move to a symmetric average inflation target, but will still refrain from specifying a time frame for the mean calculation. This will help prevent the most recent examples of under- and over-shooting the inflation target, while preserving considerable discretion in terms of the timing of policy actions. I see this discretion as irrational from a pure policy perspective, but if the FOMC’s decisions are purely rule-based, when why do we need humans in the loop at all? I doubt they want to diminish their own importance.

If I’m correct, this will be an important step in the right direction for monetary policy. This would be price-level targeting that could closely mimic NGDP level targeting, particularly if that was the goal. I just wish the Fed would go all the way and adopt a purely rule-based framework, preferably using only forward-looking market-based indicators. Otherwise, the significant discretion that this framework allows means that inflation targeting can continue to be pro-cyclical, with the Fed being typically too slow to act to prevent unnecessary volatility in output, employment, and ironically, prices.

Note: This post, as is the case with all my posts, should not be construed as offering investment advice. Such advice should be tailored to the individual investor by qualified professionals who, ideally, are fiduciaries.

Links to Data:

Economic Data Sources:

https://fred.stlouisfed.org/series/SP500

https://www.wsj.com/market-data/stocks/peyields

https://www.barchart.com/futures/quotes/ES*0/futures-prices

https://ycharts.com/indicators/sp_500_earnings_per_share_forward_estimate#:~:text=Basic%20Info-,S&P%20500%20Earnings%20Per%20Share%20Forward%20Estimate%20is%20at%20a,28.27%25%20from%20one%20year%20ago.

https://www.cnbc.com/quotes/.VIX

https://fred.stlouisfed.org/series/DTWEXBGS

https://fred.stlouisfed.org/graph/?g=Ee9i

https://fred.stlouisfed.org/series/T10Y3M#0

https://fred.stlouisfed.org/series/DGS10

https://www.cmegroup.com/trading/interest-rates/countdown-to-fomc.html

https://tradingeconomics.com/commodity/crb?user=nunote

https://www.cnbc.com/quotes/@CL.1

https://www.cmegroup.com/trading/en

https://www.spglobal.com/spdji/en/documents/additional-material/sp-500-eps-est.xlsx

https://www.cmegroup.com/markets/interest-rates/stirs/30-day-federal-fund.quotes.html