Weekly Update - Maximum employment - the Fed's new objective

Powell’s speech marked a historic shift in the way the Fed defines its dual objectives of price stability and full employment. Since January 2012, the Fed has defined stability as inflation at 2%, and full employment as being the “equilibrium” level. The two objectives are considered to be linked in economic theory – this relationship, known as the Phillips curve, means that when unemployment falls below its equilibrium level, wage rises begin to push inflation higher and it’s time for the Fed to switch to a more restrictive policy.

This theory has been challenged in recent years by persistently low levels of inflation, as measured by the Fed’s preferred metric of core personal consumer expenditures (core PCE). Since the 2% target was introduced, core PCE has averaged 1.6% and has only rarely ventured above 2%. In recent years however, the US labour market has been very strong with the headline unemployment rate reaching 3.5% before the coronavirus crisis hit, the lowest since 1968. With the jobless rate well below the equilibrium level at which inflation should have emerged, the Fed appears to have concluded that the Phillips curve was broken. In his speech last week, Powell announced that the central bank is now targeting an average level of 2% over time. This suggests that after an extended period of undershooting its objective, the Fed will be happy to see inflation stay above target to bring the average back in line. But although most reports of Powell’s speech focused on inflation, it is arguably the implications for the job market which are the most profound. The Fed has subtly shifted its main focus away from inflation and in favour of employment. Indeed, Powell noted in his speech that the “robust job market was delivering life-changing gains…, particularly at the lower end of the income spectrum” and made maximum employment a “broad-based and inclusive goal”. Looking ahead, unemployment can be too high but never too low in the Fed’s eyes.

In the near term, all this leaves the outlook for US monetary policy pretty well unchanged. Key rates – the Fed Funds – are already at the zero lower bound, core PCE at 1.3% in July is still well below target while unemployment at 8.4% is far from equilibrium. This leaves the onus on asset purchases to transmit monetary policy and help the Fed achieve its objectives. But the shift in the framework means that the Fed’s reaction function will be very different in future – Powell will hope to see unemployment fall well below pre-COVID-19 levels but is unlikely to think about tightening policy until accelerating prices have been well above 2% for an extended period of time.

Bottom line. Last week’s announcement put some upward pressure on the market’s implicit inflation expectations – the difference between yields on fixed-coupon Treasury bonds and inflation-linked securities. However, with the gap between actual and potential levels of activity still extremely wide, we do not expect any lasting rise in prices over the next few years. And with Fed Funds stuck at zero and the Fed set to continue massive asset purchases for the foreseeable future, Treasury yields are likely to remain low, pushing investors towards riskier assets. Finally, any weakening in the economy or failure to bring unemployment much lower would likely trigger renewed Fed easing, further inflaming investors’ preference for equities.

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