At Jackson Hole late last week, the Chairman of the Federal Reserve, Jerome Powell, made an historic change to its monetary policy framework. Whilst it has been discussed in the lead up to Jackson Hole, and is thus no surprise, it adopted, more formally, ‘average inflation targeting’. The Federal Reserve, like the Bank of England and many other central banks, has a target for inflation in their economies against which rates and other monetary tools are utilised to meet. However, inflation has been stubbornly low for an extended period of time, despite quantitative easing to soften the impacts of the Global Financial Crisis and more recently of COVID 19 related activity lockdowns, and even in the period of economic growth in between. As Jerome Powel stated in his speech: “If inflation runs below 2% following economic downturns but never moves above 2% even when the economy is strong, then, over time, inflation will average less than 2%.”
With near zero nominal interest rates central banks are losing one of the tools with which to manipulate interest rates in the real economy, (something which is helpful in steering their economies according to their mandates), and so it is in their interests to keep inflation expectations high. To do so, they are now publicly acknowledging the difficulties in attaining a long term 2% equilibrium and clarifying that they will delay rate rises more so now than they have historically and allow inflation to rise above 2% before tightening the screws.
Whilst widely expected, the Federal Reserve’s confirmation moved bond prices down on the day and we expect more to follow. The prospect of higher inflation in the future erodes the real return that bondholders earn on their fixed interest payments for government debt and thus makes the bonds less attractive. The yield on Treasuries that mature in 30 years’ time, which rises when bond prices fall, surged to 1.5% last week, a level not seen since June. Treasuries with 5 and 10 year maturities suffered more muted price falls and thus yield rises.
Fortunately our underweight to bonds, and our focus on short duration and inflation protected securities have served us well over this short period. A higher inflation outlook should also benefit real assets such as equities, gold and other commodities. This ‘steepening’ of the yield curve should also assist the banking sector with the prospect of improved interest margins. Nevertheless, there is still the possibility of negative rates and more quantitative easing in the near future should emerging from lockdowns prove a lengthy exercise and so it remains prudent to maintain some exposure to Fixed Income assets in a balanced risk portfolio.