The Fed's New Strategy and This Week's Key US Economic Data

The Fed's newly revised Statement on Longer-Run Goals and Monetary Policy Strategy sets a pro-growth stance for monetary policy.  Its new goal is to achieve 2% inflation over time, allowing for inflation to exceed this target "for some time" if it missed on the low side beforehand.  It means the Fed will not tighten in the face of above-trend growth that pushes up inflation above 2%.  In some ways, this sounds like an acknowledgement that its tightening in 2018 was a mistake -- which, in fact, it was. 

The roots of the issue go further back.  In the past, the Fed tended to tighten quickly once the economy began rebounding strongly from recession.  As a result, economic growth slowed sharply -- a mid-cycle pause --  leading to a reversal of the Fed tightening.   The Fed is concerned now that it wouldn't be able to ease adequately in such case because rates are so close to the zero bound.  Therefore, it won't raise rates in the early stages of recovery.

The Fed also understands the tremendous social benefits of allowing the unemployment rate to fall to exceptionally low levels, as enumerated by Fed Chair Powell in last week's speech.  In the past, fear of inflation persuaded the Fed not to let the Unemployment Rate fall below what was estimated to be its natural rate, for much of the time seen to be about 5.5%.  The one notable exception was in the late 1990s when Greenspan shifted away from tighter policy even though economic growth was strong.  He was among the first to realize the tech revolution boosted productivity and thereby allowed faster growth without inflation.  He also understood the social benefits from doing so.  The Unemployment Rate fell to 3.9% then. 

The Fed's new hands-off approach will be important in coming months because some upward price adjustments following the virus-induced shutdowns are likely.  They should only temporarily boost inflation and, regardless of policy goals, should not be targeted by tighter monetary policy.  The new policy stance ensures this will not happen.

One inflation channel that could become problematic, however, is a weaker dollar -- particularly since the Fed's new policy stance essentially gives a green light to dollar depreciation.  Regardless of the cause -- easy Fed policy, large Federal deficits, widening trade deficit, low national saving rate, unwinding of "flight to safety" demand as efforts to defeat the virus advance -- a sustained decline in the dollar could lead to higher US inflation.  It is too soon to be concerned, but something to keep in mind.  It could cause the Fed's new stance to backfire, if a weak dollar forces the Fed to tighten before the economy reaches full employment.  The problem of a declining dollar could stem from the Fed's forward-looking communication policy.  It eliminates a degree of uncertainty that otherwise would keep markets in check.

From a market perspective, the new approach is a positive for stocks and Treasury Inflation Protection Securities (TIPS) immediately ahead.  But, it is a negative for longer-term Treasuries,  pushing up their yields.  The steepening of the yield curve could eventually be a significant negative for the stock market, particularly if at some point it signals that inflation fears are getting out of hand.

This week's key US economic data should continue to show a strong Q320 recovery.  Consensus looks for an uptick in the August Mfg ISM to 54.5 from 54.2 in July.  Most other mfg surveys improved in August, and some suggest a stronger-than-consensus print.  August Motor Vehicle Sales could move up from July's 14.5 Mn Units, considering that vehicle production appears to be back to normal.  Consensus expects Initial Claims to fall below 1 Mn.  But, consensus sees August Payrolls slowing, although to a still-strong 1.425 Mn m/m increase from 1.763 Mn in July.  Note that the Claims data argue for a speedup in August Payrolls.  So, an upside surprise can't be ruled out.  The Unemployment Rate is expected to a fall to 9.8% from 10.2%.