UK Economic Outlook: Inflating Expectations
At the meeting Jerome Powell, the head of the US Federal Reserve, announced that the Fed would be changing its policy objective in two ways.
- Firstly, with regard to employment: previously the mandate was to manage ‘deviations of employment from the Committee’s assessments of its maximum level’; but this has now changed to minimising ‘shortfalls in employment from its maximum level.’ This small change in wording actually makes a significant difference to the mandate. Whereas previously an increase in employment above its ‘maximum’ was seen from a policy perspective as being equivalent to a decrease in employment, in that both required a policy response this is no longer the case. Now, if employment is above its ‘maximum’ level, the Fed need not take action. This allows the Fed to effectively run the economy ‘hotter’ for longer, so long as they can keep inflation under reasonable control.
- Secondly, they changed the remit with regards to the way they target inflation. Previously the Fed was aiming to ‘mitigate deviations of inflation from its longer-run goal.’ It will now seek to achieve ‘inflation that averages 2% over time.’ This means that if inflation undershoots the 2% target in 1 year it can overshoot by a similar amount in the future. This should give the Fed more flexibility in terms of how it implements policy over time, particularly given the low levels of inflation we have seen in recent years.
Of course saying you are going to generate inflation is one thing, actually being able to do so is quite another. The ECB has been saying that it will generate inflation for a decade and has thus far failed to do so.
The Fed however does not have a decade of inflation targeting failure behind it, and still has some room to force long dated interest rates lower; unlike the ECB, the Fed retains both credibility and some policy headroom. For Central banks, credibility is a crucial aspect of policy making. If the Fed says it will raise inflation, and market participants and consumers believe this, inflation can be generated simply through this signalling and the change in consumer (and investor) expectations. Indeed market expectations for inflation have been climbing steadily over the past few months in anticipation of this signalling. However the post COVID output gap, and the declining strength of the relationship between unemployment and inflation, could make generating inflation in the very near term harder to achieve.
Andrew Bailey, Governor of the Bank of England also gave a speech at Jackson Hole. His was much less dramatic and contained no revelations about the future remit of monetary policy in the UK. Unlike the role of Jerome Powell, this is because it is not in the gift of the Governor to change; the way the Bank of England targets inflation is set by Chancellor of the Exchequer. And it already has much wider flexibility. The BoE remit allows significant flexibility both around the 2% CPI target and allows for the BoE to consider economic growth alongside the inflation target. The BoE has certainly not been afraid to run inflation higher than target in the past when it believes that this inflation was caused by temporary factors and where restricting inflation would cause undue economic harm.
From an investor’s viewpoint, especially those investing for pension schemes, the direction inflation will take is critical and is currently subject to intense debate and scrutiny. There are good arguments on both sides. However it must be remembered that a pension scheme is not normally taking a view on inflation by increasing its exposure to inflation linked assets. Inflation causes a scheme’s liabilities to increase over time and this needs to be hedged against by purchasing assets whose value also increases as inflation goes up. Equally pension funds should be praying against deflation, given that as they generally cannot cut payments to members if inflation falls below zero, deflation can result in serious negative consequences for scheme funding.
And don’t even get me started on the RPI/CPI consultation. Inflation is likely to be the liability risk to watch most closely over the next few years, even for those schemes that are well hedged to begin with.