Farewell to the Fed’s Goldilocks approach to inflation targeting

Inflation

The Fed’s dual mandate of controlling inflation while promoting maximum employment will now see a major shift in how it interprets and responds to inflation targets. At a virtual meeting of the Fed’s annual Jackson Hole symposium, Fed Chairman Powell formally assented to an “average inflation targeting” approach, which would allow inflation to run moderately above the Fed’s 2% goal for longer periods without the Fed responding by raising interest rates. While no formal maximum inflation number was released, economists believe the range would be around 2.25%-2.5%.

Unemployment

With U.S. unemployment hovering around 10%, the Fed also hinted at a more inclusive definition of full employment as it embraces a broader interpretation of the maximum unemployment rate. This would allow the Fed to be more tolerant of low unemployment numbers while chiseling away at the long-held belief that low unemployment and low inflation cannot coexist.

Rates

The immediate interpretation by the markets of the Fed’s new strategy is that the central bank would leave rates near zero for longer than initially forecasted. This had a mixed impact on government bond yields, with the 10-year treasury yield rising sharply and nearing 0.75% before paring back some of its gains. The Fed also appeared to put the yield curve control topic aside, at least for now, which could lead to slightly higher volatility in the months to come. With long term rates at historic lows, bond issuances on the rise, and mixed interpretations of policy changes, pre-issuance hedging continues to be a theme across corporates. We’ve seen clients dusting off risk management policies, exploring forward hedging much farther forward than historically, and revisiting the economic and accounting implications of their hedge product choices in the current environment.

(Related insight: Read “Hedging future fixed-rate debt” to learn how organizations are taking advantage of low long-term rates by locking in rates on future fixed-rate debt issuances.)

Foreign currency

Following the Fed’s announcement, the U.S. Dollar (USD) fell sharply against most major currencies as markets embraced the prospect of low U.S. interest rates for longer periods. The U.S. Dollar Index, a comparison of the USD against a basket of currencies, was below 92.50 and nearing its low for the year. In addition, the resignation of Japan’s longest serving prime minister, Shinzo Abe, due to ill health, caused Japanese investors to pull back money from abroad fearing the end of a very expansionary monetary policy by the Bank of Japan. This led to a sharp rise in the Japanese yen (JPY) and other safe haven currencies.

(Related insight: Register for the webinar, “Strategic Considerations for Cross-Currency Swaps” on September 10 at 2 p.m. ET)

(Related insight: Download Chatham’s Benchmark Study Report, "The State of Financial Risk Management," to see what peer corporations are doing to manage FX risk.)

Week ahead

Although we have seen a strong recovery in jobs numbers over the last few months and hit record highs for equities this past week, much pessimism still exists around vast sectors of the U.S. economy as COVID numbers continue to rise. All eyes will be focused on the non-farm payrolls number for the month of August and whether businesses can continue to open with relaxed restrictions and rehire workers or revert to tighter shutdowns.