- Fed’s new inflation-averaging policy suggests rates will remain lower-for-longer with a steeper yield curve
- Pelosi-Meadows phone call produces no movement on pandemic-bill talks
- Fed’s preferred inflation measure expected to move higher
- Final-Aug U.S. consumer sentiment index expected to be unrevised
Fed’s new inflation-averaging policy suggests rates will remain lower-for-longer with a steeper yield curve — Fed Chair Powell on Thursday officially announced a change in the Fed’s long-term monetary policy framework whereby the Fed will now follow “a flexible form of average inflation targeting.” Mr. Powell said that Fed will target “inflation that averages 2% over time” and will aim to bring inflation above the 2% target following periods when inflation runs below that level.
However, Mr. Powell put a limit on the Fed’s tolerance of above-2% inflation by saying that “if excessive inflationary pressures were to build or inflation expectations were to ratchet above levels consistent with our goal,” then the central bank would not hesitate to act.
The Fed also essentially did away with the Phillips Curve idea that full employment contributes to inflation. The Fed adopted new language in which it will be much more tolerant of a low unemployment rate. Previously, the decline in the unemployment rate below the Fed’s estimate of a natural rate sparked market expectations of inflation and Fed tightening. However, the Fed has now largely removed a low unemployment rate as a reason for a preemptive rate hike.
The beginning of the Fed’s 1-1/2 year policy review predated the pandemic, but the results came in handy for the Fed as it now tries to convince market participants that rates will remain low for a long-time into the future. Low rates will stimulate the economy, keep mortgage rates and corporate bond rates low, and support asset and stock prices.
However, the new policy has sparked concern in the bond market about the Fed’s new tolerance for above-target inflation. Indeed, the Fed’s new policy is a recipe for a steeper yield curve, where the Fed keeps short-term rates pegged at low levels while bond yields rise on inflation worries. The 2s10s Treasury yield spread yesterday rose by +6 bp to a 2-1/2 month high of 0.59%.
The prospect of a steeper yield curve was supportive for banks, which like to “borrow short and lend long.” A steeper yield curve would mean that banks can borrow money at very cheap short-term rate levels and lend it to customers at higher yields on longer time horizons. The KWB bank stock index on Thursday rallied by +2.4% on the Fed news.
Pelosi-Meadows phone call produces no movement on pandemic-bill talks — Politico reported that yesterday’s 25-minute call between Speaker Pelosi and White House chief of staff Meadows “went nowhere,” meaning the talks on a new pandemic relief bill are still deadlocked. Ms. Pelosi told reporters after the call, “We have said again and again that we are willing to come down, meet them in the middle — that would be $2.2 trillion. When they’re ready to do that, we’ll be ready to discuss and negotiate. I did not get that impression on that call.”
Prior to Thursday’s phone call, Mr. Meadows expressed pessimism about the chance for any near-term talks. He said he thinks Ms. Pelosi will “hold out until the end of September” and then wrap a pandemic relief bill with the stop-gap spending bill for fiscal-2021 that must be passed to prevent another government shutdown on October 1.
Fed’s preferred inflation measure expected to move higher — Today’s PCE deflator, the Fed’s preferred inflation measure, is expected to move higher, seemingly on cue after the Fed yesterday moved to a more relaxed average-inflation target.
The consensus is for today’s July PCE deflator to rise to +1.0% y/y from June’s +0.8% y/y, and for the July core deflator to move higher to +1.2% y/y from June’s +0.9%. Today’s expected rise in the core PCE deflator to +1.2% would leave the measure within 0.2 points of the +1.4% level that was seen in February before the pandemic emerged as a major problem. That illustrates how inflation is recovering fairly quickly now that the worst of the pandemic is over.
The market is expecting higher inflation going forward as the 10-year breakeven inflation expectations rate yesterday rose to a 7-1/2 month high of 1.75%. The 10-year breakeven rate is currently higher than the pre-pandemic average of 1.65% seen in Q4-2019 since the market expects the Fed’s extraordinarily-easy pandemic monetary policy to boost inflation over the next 10 years, particularly since the Fed is now explicitly tolerating above-target inflation.
Final-Aug U.S. consumer sentiment index expected to be unrevised — The consensus is for today’s final-Aug University of Michigan U.S. consumer sentiment index to be left unrevised from the preliminary-Aug level of 72.8, which would leave the index up slightly by +0.3 points from July.
U.S. consumer sentiment remains depressed due to the pandemic, which saw a second surge in June-July that made it clear that the U.S. economy will remain hobbled until there is an effective and widely-available vaccine. The Conference Board’s U.S. consumer confidence index, which was reported on Tuesday, fell sharply by -6.9 points to post a new 6-year low of 84.8, which bodes poorly for today’s University of Michigan report.
China’s PMIs expected to remain above 50 — The consensus is for Sunday night’s (ET) Chinese PMI reports to show little change but remain above the expansion-contraction level of 50.0. The consensus is for China’s Aug manufacturing PMI to rise by +0.1 point to 51.2, adding to July’s increase of +0.2 to 51.1. Meanwhile, China’s Aug non-manufacturing PMI is expected to be unchanged at 54.2 after July’s small -0.2 point decline to 54.
