Fed is to change inflation-targeting framework

When the Fed started monetary normalization in 2015, it was based on the assumption that the strong labour market would result in the inflation growth. But global economy stopped working by old rules, the inflation rate doesn’t respond to low unemployment and high growth rates of wages and GDP. In the short run it means that the Fed should wait and see, that is, to make a long pause in hiking the interest rate, or it may even end it at all. In the long run, the regulator will reassess inflation-targeting framework. And that has already started.

According to New York Fed President John Williams, the central bank must guard against consumers’, businesses’ expectations for low inflation becoming self-fulfilling. Drawing parallels with Japan, I may note that the population and investors’ expectations for deflation prevents the BoJ from driving the CPI up to the 2% target even despite the massive package of fiscal stimulus. Williams suggests they make the 2% target the average for businesses cycle. That is, the inflation rate may be higher at good times and lower at hard times.

Dynamics of U.S. inflation

Source: Wall Street Journal

In the current situation, it means that the Fed will put up with the PCE higher than the target, as it still believes that the U.S. economy is in a perfect state. I believe that the monetary normalization is highly likely to be ended. Especially since the central bank states that the balance sheet will further be at at significant levels by historical standards. The U.S. dept-to-GDP ratio is lower than in the euro area or in Japan, which results from the normalization progress.

And what about limited room to manage a potential recession as the federal funds rate is not that high? According to the vice chairman of the Federal Reserve Richard Clarida, they can follow the Bank of Japan example limit the growth of the US Treasury yield. Anyway, everything is clear with the US dollar. The end of normalization cycle has turned it dependent on the incoming data. Worse economic data will draw the dollar down in the near future. Another matter is whether the opponent will be able to get use of it. In particular, it is about the euro.

Although Germany has hardly avoided recession, its budget deficit was €58 billion in 2018, the widest since German reunification. It lays the ground for the massive fiscal stimulus, which will help German economy recover soon. The wages growth in the euro-area increased from 2.2% to 2.5% Y-o-Y in the third quarter, which, in addition to low inflation expectations, lays the ground for the growth of consumption and GDP. In my opinion, if the U.S. doesn’t start a war with the EU, the EUR/USD will have a perfect opportunity to draw the rate to 1.18-1.2 till the end if the year.

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The content of this article reflects the author’s opinion and does not necessarily reflect the official position of LiteForex. The material published on this page is provided for informational purposes only and should not be considered as the provision of investment advice for the purposes of Directive 2004/39/EC.

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