Legg Mason: Fed likely to change its strategy with regard to inflation
Legg Mason: Fed likely to change its strategy with regard to inflation
By John Bellows, portfolio manager at Legg Mason affiliate Western Asset
The Fed is likely to change its strategy with regard to inflation. In particular, the Fed is considering adopting a “makeup strategy,” under which policymakers would seek to have inflation to be above 2% in some periods to compensate for the periods in which it falls below 2%. In keeping with the theme of limiting surprises, a number of senior Fed officials have recently signalled a preference for such a strategy. There are still some details to be ironed out, but the movement in this direction is clear.
A process that is designed to limit surprises is unlikely to have much of a market impact on inflation expectations, and the principal investment implication is that the Fed’s new strategy makes further rate hikes this year even more unlikely.
The Fed is also unlikely to cut interest rates to support inflation, but there is another way in which it could make good on a new average inflation targeting strategy, as the above approach is called. If inflation were to increase later in the year, the Fed could simply stay on hold and let inflation rise above 2%. This wouldn’t be easing in an outright sense, but the Fed would argue that it was easing relative to its previous baseline, and therefore counts as taking action to get inflation above 2%. In such a scenario, inflation expectations might respond by moving modestly higher.