It was a big moment today for the Fed and the future of FOMC policy.
Fed Chair Jerome Powell announced that for the first time, the Fed will look to average inflation at its 2% target overtime, rather than opting for a policy of tightening financial conditions at the first hint of above target inflation or when unemployment approaches its lower bound (in the past there has been the assumption that low unemployment would cause inflation and the Fed has tightened based purely on this… though in reality, the low unemployment never actually led to higher levels of inflation).
The practical implication of this shift in policy is that, going forward (as in, over the next 3-5 years or even more) the Fed will tolerate inflation of above 2% for a prolonged period of time in order to make up for over a decade of below target inflation.
Powell also noted how the Fed would not be placing maximum employment at the heart of its policy strategy, rather than just inflation and said it would ensure that employment returns back to maximum levels. Given that employment was at 3.5% prior to the pandemic and is now around 10%, and the Fed has not forecast a return to pre-pandemic levels of employment over its forecast time horizon (which goes into 2023), policy is set to be accommodative for quite some time.
As such, the initial kneejerk reaction of the market was a classic dovish move; one of USD weakness combined with strength in USD majors (namely in risky AUD, NZD and CAD) as well as in stocks, bonds and gold.
However, Powell did not outline any specific details as to how this new regime of average inflation targeting would work. As in, no answer was given to the question of how long the Fed will tolerate above target inflation, or how much above target the Fed will tolerate inflation.
A smart move if you ask me, as this gives the Fed maximum flexibility going forward, whilst placating markets who desperately wanted the signal of this policy shift. But, given the lack of specifics, there is still a risk of dovish disappointment going forward (the Fed could outline average inflation conditions that are not quite as accommodative as markets want).
This, combined with the comment that “any inflation overshoots will be moderate and will not go on for long periods of time” saw markets quickly reverse much of the initial knee jerk dovish reaction.
USD is now up on the day, with DXY back above the 93.00 mark.
FX markets will now be avidly looking forward to the September meeting; markets will be hungry for more specifics on the exact conditions the Fed would like to see in order to start tightening monetary policy (i.e. by raising rates or withdrawing QE).
Moreover, with the Fed having formally now moved towards average inflation targeting, other global central banks might soon be mulling the same thing… this could cap further USD downside.
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