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Why the Federal Reserve’s bid to boost US inflation is good news for Asia
- Fed’s switch to allowing inflation above 2 per cent means US rates will stay lower for longer, boosting demand for higher yielding bonds, particularly in emerging markets
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The US Federal Reserve recently announced that it will adopt a new monetary framework. It will move to an average inflation target of 2 per cent, instead of treating 2 per cent as the ceiling. Put another way, the Fed has signalled that, to achieve the average, it will be willing to tolerate inflation running hotter and higher for a limited period. It also indicated that it accepts the idea that the job market could stay strong without leading to a surge in inflation.
The announcement was not a complete surprise, since the Fed has been transparent in its review. However, it came a little earlier than expected, and most investors anticipate that this would be discussed in more detail in the upcoming Federal Open Market Committee meeting on September 15-16.
With this policy shift, the Fed is basically hoping to use its credibility to generate appropriate inflation pressure. Ideally, businesses and individuals would anticipate higher inflation and incorporate this into their investment, pricing and wage decisions. It then becomes a self-fulfilling prophecy for inflation to pick up.
Some investors are sceptical about whether this will be successful. Inflation in the United States has stayed low despite an extended period of zero interest rates during the global financial crisis. The euro zone and Japan have adopted a negative interest rate policy and aggressive asset purchases in the past decade but, on average, inflation has failed to materialise, much less return to their targets.
There are structural factors that drive prices other than the level of interest rates, such as demographics and globalisation trends, which are beyond central banks’ control.
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Given that the US economy has seen its inflation running below target for a long time, the latest shift implies that the Fed will allow inflation to spike somewhat without immediately tightening monetary policy, such as reducing asset purchases or raising interest rates.
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