Written in collaboration with Allison Boxer, US Economist at PIMCO
On 16 September, the Federal Reserve surprised many observers by releasing new forward guidance on interest rates earlier than anticipated. This follows another earlier-than-expected release of its framework review conclusions during the Jackson Hole symposium last month.
However, the lack of market reaction suggests that many investors are not convinced that the Fed’s new guidance represents any material shift in policy. Indeed, we wonder if the Fed leadership is using surprises and emphatic language to try to compensate for a Federal Open Market Committee (FOMC) that may not be fully on board with a more significant regime shift.
Outcome-based guidance morphs into forecast-based guidance
As expected, Fed officials forecast that the policy rate is likely to be on hold through 2023 (see the Fed’s September 2020 Summary of Economic Projections). With their forecasts for above-consensus U.S. growth but core PCE inflation still at just 2% in 2023 (PCE, or personal consumption expenditures, is the Fed’s preferred inflation measure), it’s no surprise that only four Fed officials expect interest rate hikes over the next three years. Indeed, PIMCO forecasts U.S. inflation will take several years to return to target given elevated unemployment and slack in the economy.
The surprise was the introduction of interest rate guidance into the September FOMC statement. The Fed states it will now be on hold until the economy is at maximum employment and “inflation has risen to 2 percent and is on track to moderately exceed 2 percent for some time”(our emphasis).
We found two things surprising about the guidance around the Fed’s inflation target. First, Fed officials had strongly signaled in speeches and interviews over the past several weeks that September would be too early to provide interest rate guidance. Second, the forward guidance is forecast-based, with inflation only needing to be “on track” to exceed target in order for the Fed to start to tighten policy. It’s a hawkish surprise, in our view. Following the results of the framework review, we had anticipated a more significant change, with the Fed tying interest rate hikes to actually overshooting 2% PCE inflation (and thus achieving its new average 2% inflation target), instead of just expecting to overshoot. The lack of market reaction in inflation breakeven rates following the statement release suggests many investors were also anticipating bolder, outcome-based guidance.
We also find this forecast-based approach somewhat at odds with Fed announcements following the longer-run framework review. One of our major takeaways from the review was to expect somewhat less emphasis on traditional monetary policy rules. Fed Chair Jerome Powell has repeatedly noted the considerable uncertainty around NAIRU and r* (the non-accelerating inflation rate of unemployment and the natural interest rate, respectively). Given this backdrop, we looked for the guidance to focus more on the outcome of inflation averaging 2%, instead of forecasts. However, we do note that in referring to maximum employment in the September statement, the FOMC codified that it will not preemptively hike interest rates if unemployment is low – the other significant change that resulted from the framework review.
We suspect the Fed’s back-to-back surprise announcements may have been aimed at guiding investors’ interpretation of the policy shifts as major changes. Chair Powell also spent considerable time during the press conference emphasizing that this is a “strong and powerful” approach to forward guidance. However, we believe the Fed may need to do more to convince market participants.
It’s possible the forward guidance announced in September reflects differences of opinion on the committee. Since the framework review was released, some regional Fed bank presidents have offered diverging interpretations of flexible average inflation targeting. Some officials were only comfortable with inflation overshooting the 2% target by 25 to 50 basis points, while others look to make up much more of the past shortfall of inflation from target.
With interest rates unlikely to rise anytime soon, the Fed has time before it needs to address these uncertainties. But in the longer run, markets will need more clarity on what “average 2%” really means. Otherwise, the Fed risks a premature tightening of financial conditions. Is the Fed aiming for a larger paradigm shift, under which it would allow inflation to overshoot and average 2%? Or is this a more modest evolution of the existing framework, where the same models are used with somewhat more patience than the last hiking cycle?
In our view, with inflation running persistently below target for the past decade and given the challenges the Fed and the U.S. economy face in today’s low rate environment, a bolder approach may make sense. In the meantime, Fed observers and investors will be watching closely for more shifts or surprises.