US Inflation: The Fed's Hot New Approach

US Inflation: The Fed's Hot New Approach

over 3 years ago2 mins

The chairman of the US Federal Reserve is expected to announce a new era in the central bank’s approach to inflation on Thursday – but allowing price rises to “run hot” could see some investors scalded 🥵

What does this mean?

The head of the Fed has overseen a busy couple of years since taking the helm in 2018. That December, the central bank raised interest rates again and made borrowing money more expensive in order to keep inflation around its long-term 2% target. A month later, however, the Fed paused further planned rate rises; by July, it was cutting them in a bid to keep the US economy expanding.

Then came coronavirus. The Fed responded by slashing rates to near zero and unleashing an unprecedented range of financial support – but American economic growth has still taken a nasty knock.

Now, in stark contrast to past policy, the central bank appears determined to push the rate at which prices rise higher. From being an oft-undershot ideal, 2% could become the “average inflation” target across an as-yet-unspecified period. When price rises have, as at present, been consistently lower, inflation may be allowed to run hotter for a while.

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Interest rates will likely remain at rock bottom until that average is achieved – but the idea is that the Fed would then raise them and regain some room for maneuver in future economic crises. Whether that pans out as planned, however, is up for debate… 🤞

Why should I care?

The Fed is intent on preventing the US from following in the footsteps of Japan and the eurozone – both of which have been plagued by persistent low growth and weak inflation. Its plan to support economic growth through greater flexibility on inflation should be good for American investors in the near term; all else equal, higher prices mean higher profits for companies.

But not everyone’s on board with the “average inflation” strategy – including some of the Fed’s governors. The central bank's already helped US stock prices recover from coronavirus, and the country’s economy is expected to rebound too. Some investors worry a little extra inflation could quickly turn into a lot – and the high interest rates required to rein price rises back in could bring the US economy to a standstill 🤦‍♂️

As seen in December 2018, such scares can lead to stocks selling off sharply. And one group of investors who may be particularly keen to avoid any further volatility in 2020 are the hedge funds who specialize in exactly that. Many of them have lost money this year due to, er, betting against volatility…

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