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Inflation and What Truly Worries the Fed

August 31, 2020 By Mircea Vasiu

When the Federal Reserve announcement meant that inflation is likely to rise at the Jackson Hole Symposium last Thursday, there was little reaction from the market.

For example: although popping above 1.19, the EURUSD did not have the strength to continue higher. Instead, the U.S. equities made new highs, enjoying the new framework.

Fed Launching the AIT

For many market participants, the Fed’s decision to let inflation overshoot its target comes as a reaction to the coronavirus crisis. It may be that the crisis speeds things up, but low inflation or the inability of developed central banks to reach the targeted level of 2% is not something new.

The ECB, for instance, began a review into its monetary policy framework when Christine Lagarde took the helm of the central bank. However, this was back in 2019 before the pandemic. The ECB said it would publish its findings a year later.

Now that the Fed has adopted Average inflation targeting, it will look at average values to reach the 2% level. In other words, we need to see much higher inflation in the future, couple it with the inflation levels from the past, and see if the average is close to the 2% target. Or, to see if the average is rising towards the target – that is when the Fed will signal a change in the monetary policy stance.

However, the Fed may be forced into such a move due to forces beyond its control. Demographics do not help. A chart showing the births in the United States in the last 25 years shows a strong correlation between demographics and U.S. inflation. Judging by the looks of it, if the historical correlation holds, the next 25 years do not look well for higher inflation. Hence, something needed to be done, and the Fed did it – it altered its price stability mandate.

But this is not just the Fed. Other central banks had the same problem. The Bank of Japan, for instance, has been fighting lower inflation for decades and the ECB has a hard time sending it to target too.

Therefore, look for the Fed move to signal a shift in how central banking views inflation. In the end, the shift will affect everyone’s pockets.

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