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Powell outlines shift to average inflation targeting, running labour market 'hot'. Market gives an initial thumbs up: equities higher, curve steeper, inflation expectations slightly higher

Currencies
Powell outlines shift to average inflation targeting, running labour market 'hot'. Market gives an initial thumbs up: equities higher, curve steeper, inflation expectations slightly higher

Chair Powell announced the Fed’s widely anticipated shift to an average inflation targeting regime overnight, essentially endorsing an even longer period of low rates.  Markets are still digesting the speech but the initial reaction is a modest tick of approval.  The S&P500 is higher, the US yield curve has steepened sharply, market-based inflation expectations have risen a little and the USD is little changed.  The NZD is higher against all currencies bar the AUD due to firmer risk appetite.

Fed Chair Powell gave his long-awaited speech on the Fed’s review of its monetary policy framework at the (virtual) Jackson Hole symposium overnight.  It was, unsurprisingly, dovish.  First, the Fed confirmed widespread speculation that it would adopt an average inflation targeting regime, whereby it will actively aim for inflation “moderately above 2% for some time” following those periods where inflation has been running below target.  Powell refused to give a precise formula for how the Fed would judge the appropriate degree of overshooting and over what time period, but the message was clear: the Fed won’t be hiking until inflation has spent a period of time above 2%, so rates will be lower for even longer compared to past cycles.

The new regime marks a shift from the Fed’s previous modus operandi where it always targeted 2% inflation, irrespective of previous shortfalls.  The Fed’s shift stems from a concern that inflation has persistently averaged less than 2% since the GFC (Core PCE inflation has averaged 1.6% since 2010), which risks becoming embedded in inflation expectations and, at the zero lower bound, makes it more difficult to get real interest rates lower to stimulate the economy.  By targeting 2% inflation on average, and in the immediate horizon that means aiming for above 2%, the Fed hopes to lift inflation expectations and lower real interest rates.  Powell didn’t say how the Fed expects to achieve above 2% inflation (ie. whether more bond buying is warranted).

The second key point was that the Fed said its interest rate decisions would be based on its "assessments of the shortfalls of employment from its maximum level", rather than the previous "deviations from its maximum level."  The Fed is now concerned only with the labour market being underutilised.  If we compare that to the most recent Fed tightening cycle, the Fed started hiking rates in December 2015 because the unemployment rate was seen to be below its long-run sustainable level and, based on a Phillips curve framework, that was expected to lead to higher inflation in the future.  But the experience in recent years has been that the unemployment rate was able to fall to very low levels (as low as 3.5%) without generating significant inflation.  The Fed is saying it doesn’t want to short circuit a recovery in the labour market unless inflation is a real constraint.  The message is that the Fed will not hike rates pre-emptively this time: it wants to see the ‘whites of the eyes’ of inflation before doing so.

The market is still digesting the implications of Powell’s speech although it’s fair to say markets had accurately anticipated the shift towards an average inflation targeting regime.  Initial market moves suggest a tentative ‘thumbs up’ to the Fed’s new approach.

The US yield curve has steepened sharply, with rates little changed out to 3-years (consistent with the Fed’s lower for longer pledge) but 6bps higher at 10-years 0.75%) and 9bps higher at 30-years (1.5%).  The US 10-year Treasury yield is now at its highest level since mid-June, although it remains extremely low in absolute terms.  The first Fed hike is priced for around four years from now.  US market-based inflation expectations (so-called ‘breakeven inflation’) have increased, albeit only modestly, which the Fed will be encouraged to see. The 10-year breakeven inflation rate is 1bp higher, at 1.74%, and is close to its highest levels of the year.  A steeper curve, in combination with higher inflation expectations and rising risk assets, is an endorsement from markets.

The S&P500 has moved higher (+0.4%), and is near its highs of the day.  The steeper yield curve has benefited banks (+2.6%), which have outperformed the broader market.

Also supporting equity markets, and risk assets in general, have been encouraging developments around COVID-19.  The US FDA announced emergency use authorisation of a COVID-19 test designed by Abbott Laboratories which produces results in just 15 minutes and costs only $5 per test.  The company said it planned to produce 50m of these tests by October and Politico reported that Trump had already ordered 150m tests (effectively scooping this year’s supply).  The development should allow for more extensive testing and substantially reduce the lag between testing and results.  Abbott’s share price rose 8% on the news.

Separately, US pharmaceutical firm Moderna released encouraging initial results from its phase 1 trial on its experimental vaccine.  Moderna, considered one of the frontrunners in the race for a vaccine, said its vaccine produced high levels of neutralising antibodies in older people.  This is considered important because older people often don’t respond as well to vaccines.  Moderna’s share price was down 4% on the day.

Currency movements reflect a risk-on pattern, with gains in the AUD (+0.4%) and NZD (+0.3%) and a fall in the JPY (-0.6%).  The USD itself is more or less unchanged from yesterday, looking through some volatility around Powell’s speech.  The Bloomberg USD index remains near two-year lows.  If the Fed is successful in engineering higher US inflation expectations, and consequently lower US real interest rates, this should be a downward force for the USD.

The NZD made a three-week high overnight and trades this morning around 0.6640.  The NZD has made gains on all the key crosses expect for the AUD.  The NZD/AUD cross has slipped marginally, to around 0.9145.

The focus on Powell’s speech and encouraging COVID-19 news from Abbott and Moderna has taken some of the focus off the continued deadlock in fiscal stimulus negotiations.  Republican Senate leader McConnell said the two sides had reached a stalemate, although he retained hope for another stimulus package.

In economic data, the second estimate of US Q2 GDP was revised slightly higher, but it still shows an enormous shrinking in the US economy in Q2.  The market is more focused on higher frequency data (i.e. how the economy is recovering from this big hole) and COVID-19 developments (both potential vaccines/treatments and social distancing restrictions).  Initial jobless claims fell back last week, close to 1 million, but remain at extremely high levels.

NZ rate moves were subdued yesterday, with around a 1bp fall in swap rates and bond yields.  The focus in the session ahead for the domestic rates market is what the RBNZ announces at 2pm for its bond buying for the week ahead.  The RBNZ lifted its government bond buying from $940m before the MPC to initially $1.09b and then to $1.35b this week.

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Source: CoinDesk

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1 Comments

NZX must be in deep doodoo.. hasn't opened yet. NZ is looking a bit amateurish right about now. I'd hate to be a Spark IT tech or the CEO!!

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