What a shift in the Fed’s monetary policy framework could mean

Market watchers obsessing over an impending rate cut from the Fed might be overlooking another policy decision that could impact markets, according to a new report from Manulife Investment Management.

In the macroeconomic update portion of the firm’s biannual Global Intelligence report, Frances Donald, chief economist and head of macroeconomic strategy with Manulife Investment Management, commented on anticipated cuts to the U.S. key interest rate.

While markets are expecting the Fed to cut rates almost three times over the next 18 months beginning in September, Donald wrote that Manulife is expecting the Fed to cut rates twice over that time span, with the first cut likely coming in the fourth quarter.

But she also said the current fixation on impending rate cuts ignores another potential Fed decision that could be of greater consequence to investors.

“Markets will no doubt obsess about when the Fed will cut rates, but I think that risks missing a more important development that’s currently taking place and could have important longer-term implications for investors,” she wrote. “Recent communications from the Fed suggest it might be shifting its monetary policy framework.”

Donald noted that the rate of inflation in the U.S., which has consistently fallen below the target rate of 2% in recent years, has led to the Fed becoming “increasingly focused on allowing a prolonged and persistent inflationary overshoot that will bring average inflation higher and closer to its 2% mandate.”

While Manulife doesn’t expect the Fed to drastically change its monetary policy framework this year, Donald said that even an informal move toward getting inflation above 2% “would represent a significant and structural dovish pivot on its part, signaling its intention to stoke inflationary pressures more aggressively than at any time in the past 10 years.”

Such a move, Donald observed, could indicate that an overheating economy by itself would no longer be sufficient reason for the Fed to hike rates if inflation is below 2%.

“More important, if the Fed were indeed successful at nudging inflation expectations higher, we could expect the U.S. yield curve to steepen, as the front end will likely remain anchored as the longer end rises,” she added. “For now, however, we’ll wait for the outcome of the Fed’s policy review.”

Read the macroeconomic update, as well as the full Global Intelligence report.

Staff

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