Fed Policy Shift Could Keep Rates Lower For Longer

In a major policy shift, the U.S. Federal Reserve is moving away from a targeted inflation rate of 2% to a policy of “average inflation targeting.” Kim Parlee speaks with Scott Colbourne, Managing Director, Global Active Fixed Income, TD Asset Management, about what this means for markets.


– A lot has been going on in the markets, and especially with the Federal Reserve, which is changing its policy in terms of how it manages inflation. This was pretty significant news, and here to explain what it all means, Scott Colbourne. He is managing Director of Global Active Fixed Income at TD Asset Management.

Scott, it’s great to see you. And can you maybe just back up and tell us a bit about how significant this decision was? The Fed has come out and said they don’t have a hard target constructed to a timeline, but rather, it’s going to be a more flexible approach to inflation. Why does that matter to the markets?

– Hi, Kim. Yeah, it’s pretty important. About a year and a half ago, the Fed undertook to review its strategy, communication, and tools. And what they announced last week at the Jackson Hole meeting was a new framework. And basically the headline of it is, now we’re going to target average inflation.

So really, when you look at inflation, the Fed has really missed that 2% target for a long time. And so basically, the Fed is now saying, look, we’re going tolerate an overshoot on inflation. And really at the end of the day, what does that mean for investors? It means that they’re going to have pretty low short term interest rates for a long period of time. So we’re going to see a very accommodative Fed for a number of years. Right now, the dot plots go up to 2022. We’ll probably see it four or five years out with very, very low, if not unchanged, short term interest rates from the Fed.

– I think a lot of people are expecting something– you know, some policy change. But hearing that you could have, you know, unchanged rates for four to five years is, I think, jaw dropping to a lot of people.

– Yeah, it really has huge implications for a lot of different asset classes. Short term interest rates are going to be on hold, they’re going to– you know, they have a mixture of policies that they can use– tools, if you will. You know, we’ve got this sense of now the willingness also to tolerate overshoots on employment as well. That was another big announcement out of the Fed that surprised the market– that is let the employment market run hot.

So you’ve got a combination of willingness to target an overshoot on inflation, a willingness to let employment run hotter than it has in the past. So the old analogy of the punch bowl being removed by the Fed, really going to see an accommodative policy going forward from the Fed. And it’s going to have implications for equities. It’s very supportive. You’ll probably see a weaker US Dollar because there’s no more real yield advantage. For bond investors, it’s going to be a challenge.

Really, we have very low interest rates right now, around 60 basis points here in Canada and the US on 10-year rates. So how much lower are they going to go? So you really have to think about what that means relative to inflation, which is a negative return, and what it means for sort of long term returns as well. So it’s huge implications, and it’s going to feed into other central banks as well.

– Let me ask– you mentioned equities, you mentioned bonds. This, obviously, is going to impact I think decision making for businesses and how they invest, decision making for portfolio managers in terms of where they’re deploying money. And I think that’s a much larger conversation we’ll have you back to have. But I also just want to just dig into one piece of that– you talked about negative yields. What are the implications if you have a consistent negative yield?

– Yeah. So at the moment, the Fed has said, look, of all our tools in the toolkit, we’re not going to use yield curve control or negative interest rates. We’re not going to move Fed funds to negative. We’re going to use quantitative easing forward guidance. So you’ve got really an expectation that central banks are going to keep interest rates low on a nominal basis. I think really what people have to think about is this notion of real returns, which nominal yields less inflation.

So if you’ve got a 50 basis point 10-year rate, less inflation, it’s a negative return. And that purchasing power is eroded over time. When you look back in history, that is a way that governments have historically looked at eating away at the real debt load. And it’s a notion that we call financial repression. So it is a real challenge. So I think the most we can expect right now is just a period of very low nominal interest rates, which is going to, as you alluded to, very supportive for other asset classes.

– We’re going to leave it there, Scott, but we’d love to have you back. And again, we’ll dig into this a little further. I think everyone is still digesting what this could all mean. Scott Colbourne, thanks very much.

– Thanks, Kim. Look forward to it.

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Editor’s Note: The summary bullets for this article were chosen by Seeking Alpha editors.

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