What does the Fed’s average inflation targeting mean for investors?

On the latest edition of Market Week in Review, Senior Portfolio Manager Megan Roach and Research Analyst Brian Yadao dig into the week's economic data, the annual Economic Policy Symposium from the U.S. Federal Reserve (the Fed) and a week of market optimism.

Expectation-beating economic data

Regarding economic data, Roach noted that it was mostly good news on the data front this week, observing that, in the U.S., new home sales and durable goods orders are showing that U.S. consumers are beating expectations. According to Roach, home purchases were up 36% in July over last year, and new car and truck purchases were strong as well. She said: "I think the view is that a lot of this is pent-up demand from when we were at the peak of lockdowns in the spring, but, certainly, low interest rates have also helped spur those larger purchases."

Overseas, the business climate index in the eurozone showed companies turning more optimistic on the economic recovery. In Germany specifically, the ifo Business Climate Index came in better than expected, at a reading close to its pre-virus levels. In China, industrial profits were reported to have increased by nearly 20% year-over-year, versus a reading of about 11% in June.

"I will say, on the less-stellar side, we did have some data in the U.S. on consumer confidence, which showed a notable drop in July," said Roach. "And we continue to have weekly jobless claims of about a million per week, and that's sort of plateaued over the last few weeks."

What is average inflation targeting?

Roach commented that the most anticipated event this week was the Federal Reserve's annual Economic Policy Symposium, which was held virtually this year, where Chairman Jerome Powell previewed their monetary policy framework review. Roach said: "This is basically the big strategic review that, frankly, economists and market participants have been talking about for months."

Roach stated that the expectation going into the week was that Fed Chairman Jerome Powell would lay the groundwork for the Fed to launch what is called average inflation targeting, which is exactly what happened during his speech on Thursday morning. Roach explained it this way: "Instead of raising interest rates as soon as inflation hits 2%, the Fed will allow periods of overshooting the 2% level to make up for past undershoots. This equates to a more dovish policy of lower interest rates for longer over an economic cycle. For this expansion specifically, it reinforces what the markets are already pricing in, which is for the Fed to remain at its zero-interest-rate policy through roughly 2024." Roach added: "I would say a benefit of this for the real economy is that this change in policy would likely allow labour market gains to run more broadly and employment eventually to be higher. And that should lead to higher wage growth before short-term rate are raised by the Fed in the future."

Investors building on the optimism

So how did markets react to all these developments? Roach said, "Between what the Fed's doing, hopes for more fiscal stimulus, positive headlines this week on COVID vaccine and treatment developments and potential progress on the China/U.S. phase-one trade deal, investors have certainly built on the optimism that's come in the third quarter." While the Fed's average inflation policy was very well telegraphed to the market ahead of time, yields on the 10-year Treasury did jump quite a bit on August 27, to about a quarter of a percent. Roach also noted that the yield curve steepened to its highest level in about two months, which mostly benefited the banking and real estate sectors. Roach said: "The view is that higher inflation and positive vaccine news could lift this 10-year rate modestly to just under 1% over the next 12 months."

Finally, Roach noted that markets are up about two-and-a-half percent this week, led by U.S. stocks. The S&P 500® has closed at an all-time high for the past six consecutive sessions and that index is now up by about 56% from its March lows. "While this may sound extreme," said Roach, "our view is that given the positive cyclical signals we're continuing to see play out, we remain in a neutral risk range for equities-versus fixed income and would need to hit notably higher signals, indicating a level of euphoria, before advocating for a risk-off or more defensive positioning in stocks."

 

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