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The Problem

When did the Fed raise rates?

Heading into the fourth quarter of 2018, the Federal Reserve (Fed) had just finished raising rates for the eighth time since 2016 and signaled a willingness to raise rates three more times in 2019. For the most part, investors believed them. Short-term interest rate markets were pricing in two rate hikes by the Fed over the same timeframe.

The best laid plans often go awry, and in the fourth quarter, US financial markets suffered a sharp and steep selloff. Financial conditions tightened, and the sustainability of the nearly decade-long economic expansion was called into question. Facing external pressure to stop hiking rates from investors and politicians alike, the Fed underwent a complete 180 degree change in communication and reaction.

Will the Fed raise rates?

By January, Fed Chairman Jay Powell, as well as many other members of the Federal Open Market Committee, noticeably increased their emphasis on so-called “data dependency.” In other words, they became determined not to further tighten financial conditions with US economic growth decelerating.

For the first time in years, the Fed dipped back into the “well” of forward guidance. Meaning that they attempted to assuage market concern without actually changing interest rates. This type of verbal market influence is sometimes referred to as jawboning, and over the first few months of the year, Fed jawboning helped calm market anxieties, leading to a recovery in US financial markets.

Within the ongoing Fed communications are hints of a potential policy change in the works. Such a change would alter asset market pricing and be the biggest shift since quantitative easing’s enactment. The change is in regards to their inflation mandate, moving away from a de facto inflation ceiling system to a new price level targeting approach.

What Do Fed Rate Hikes Mean?

The Federal Reserve has three main objectives: maximum employment, stable prices, and moderate long-term interest rates. The first two objectives, full employment and low inflation, are commonly known as the Fed’s ‘dual mandate’ because they tend to move inversely to each other.

The Phillips Curve describes this inverse relationship between unemployment and inflation. Simply put, as the unemployment rate gets lower—and the economy gets hotter—inflation should rise. When debating an interest rate hike, the Fed’s dual mandate requires policymakers to consider both sides of this dynamic.

How Does the Fed Decide to Raise Rates?

In determining the right balance between unemployment and inflation, the Fed looks at what it considers to be the long-run normal for unemployment and inflation.

For unemployment, the long-run target is always moving (known as NAIRU, Non-Accelerating Inflation Rate of Unemployment). For inflation, the target has been static at 2%. When determining whether to raise rates, the voting members of the FOMC (Federal Open Market Committee) attempt to gauge the state of the economy against those two measures.

How Does Monetary Policy Affect Inflation?

The FOMC has historically judged “stable prices” at a 2% medium-term annual inflation rate in order to anchor inflation expectations. Inflation expectations describe how much inflation people expect in the future.

The market views the 2% target as a ceiling, meaning the closer inflation and inflation expectations get to 2%, the more the market expects tightening by the FOMC.

The Potential Change

What is the Current Rate of Inflation in the US?

During the last decade, the Global Financial Crisis re-anchored inflation expectations well below the 2% level, forcing the policy rate to remain close to zero percent. Such a low policy rate is problematic.

Ultra-low rates handcuff the Fed’s ability to steer the economy. Cutting interest rates is the Fed’s preferred tool, but it is hard to justify cutting rates when they are already very low. For example, during a downturn, the average rate cut cycle is about 5.0% worth of Fed rate cuts to stimulate growth. This is clearly not possible with the Fed policy rate between 2.25-2.50%.

Great, now what should we do…?

The Federal Reserve is currently conducting an evaluation of what it should do. It is studying its static 2% inflation target right now, with the results likely to be announced within the coming quarters.

When it’s done, we believe the Federal Reserve will announce a new inflation policy known as ‘price level targeting.’ Price level targeting explicitly enables the Fed to overshoot its old 2% inflation ceiling during the current cycle, but with 2% remaining the central tendency.

Whereas the old policy could have been thought of as a permanent 2% inflation ceiling, price level targeting policy can be thought of as a 2% average.

Price level targeting policy will also mean that any undershoot of the inflation target in the past will need to be made up for in the future. In other words, if inflation runs around 1% for several years, then expect the Fed to target around 3% inflation for several years in order to reach the 2% average target level.

For Illustrative Purposes Only.

What will happen when interest rates go up?

This policy will have major long-term implications. In order to generate more inflation, it will lead the Fed to keep interest rates well below what the current system would recommend.

Investing Implications

There are two main questions investors should look to answer:

1. What will be the effectiveness of the new policy?
2. What are the market & economic implications?

How effective will this new policy be?

The answer hinges on whether the US economy, with its aging demographics and high debt load, can still generate excess inflation.

The Phillips Curve has been incredibly flat this cycle. Despite unemployment at historic lows, there has been very little inflation. It has led to rightful skepticism of the prospects for higher inflation.

We find it difficult to forecast how much more effective this policy change will be at generating inflation.

What are the investment implications?

Assuming price level targeting works, the investment implications are being overlooked by the market. We believe this is short-sighted and see three big implications to fixed income markets.

The first major change will be a rapid repricing of implied volatility in rates.

Currently, the MOVE index (an implied volatility index for Treasury options) is closing in on all-time lows.

Stability breeds instability, and we believe a change in the Fed’s inflation target can be the spark that lights the kindling. The market has been lulled into a false sense of certainty that may be absorbed through higher volatility in rates.

Second, yield curves in US Treasuries will steepen.

The inflation component of interest rates can be broken down into two different variables.

The first is outright inflation expectations, which we can model with different assumptions. The second variable is the inflation uncertainty premium, which mainly impacts the more distant future. This longer run uncertainty premium has been depressed over the past decade, in part due to the Fed’s 2% inflation ceiling.

All else equal, the removal of the 2% inflation ceiling will lead to a higher uncertainty premium, particularly on the long end of the curve, as well as higher interest rates. Additionally, as the Fed tries to make up for years of far-too-low inflation, they will likely keep the short-term policy rate below normal levels, further contributing to a steeper yield curve.

The third investment implication is a weaker US dollar.

Easier monetary policy and higher inflation xpectations may cause the Fed to keep real rates extra low. Compared to interest rates across the globe, this would be to the detriment of the dollar.

Higher inflation targeting may also hurt the purchasing power of US consumers. In theory, if the Fed is more willing to let prices rise, it should lead to a weaker currency. The US dollar is already overvalued on most purchasing power metrics, and allowing for higher inflation should expedite the weakening of the dollar.

Going Forward

Lastly, we would like to touch on the risks associated with a change to price level targeting.

Due to the large, multi-year inflation undershoot, we expect interest rates to be lower than what would have typically been implemented. This loosening may lead to easier financial conditions and the possibility of a late-cycle reflationary environment.

History suggests, however, that overly easy policy causes large booms and terrible busts. We fear more significant risks once excesses build. The Fed may need to meaningfully tighten financial conditions, including sharp interest rate hikes that could ultimately lead to a more catastrophic cycle end.