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Recently, the Federal Reserve announced it will change its approach to monetary policy in order to target an inflation rate that may average above 2% over time. What does this change mean for investors? RBC GAM’s Chief Economist, Eric Lascelles, weighs in. [8 minutes, 10 seconds] (Recorded September 23, 2020)

Transcript

Hello and welcome to The Download. I’m your host, Dave Richardson, and I’m really pleased to be joined today by Eric Lascelles, the hardest working economist in Canada and Chief Economist at RBC Global Asset Management. Eric, always great to have you on.

Gosh, thanks for having me.

The Fed and economics [have been] front and center in the news over the last week or so. Around a little bit of change in philosophy about the way the Fed thinks about inflation, and managing monetary policy around inflation. Could you explain what happened, and if there’s any implications at all for everyday investors around that change in policy?

Absolutely. So really what’s happened is, over the span of a decade, we’ve gone through a period of time in which inflation has been unusually low. Generally speaking, below where the Fed wanted it to be. It wanted to be at 2%, and it was getting a whole lot of 1.5%. So not a wild deviation. But it was missing persistently on one side, and simultaneously we had a financial crisis a decade ago. We’ve had a different sort of crisis over the last year. And central banks and monetary policy can run into trouble when you cut interest rates, and you get them down to zero or thereabouts. That’s about as far as they can go. And without getting into the minutia and the detail, essentially what the central banks actually care about is the interest rate after inflation. And the problem is, when you’re in a recession, the expectations for inflation generally go down, which makes sense. Inflation does tend to be lower in recessions. The problem is that, after inflation, interest rates are actually going up through the recession after they’ve bumped into that zero lower bound. Long story short, they’ve changed the way they’re targeting inflation in the future, with the hope of fixing some of those problems. And so probably the most eye-popping change is that instead of always targeting 2% inflation, they will now target, for the moment, a higher rate of inflation. It’s not an exact number. They’ve been coy about that. It’s still a fairly qualitative thing, but they’d be tolerant of inflation running at least a little above 2% for a period of time. The reason for that is they’ve just gone through a decade of inflation below 2%. So they’re just averaging things out. In fact, that’s the term they’re using. Average inflation targeting sounds totally reasonable. It is ultimately pretty reasonable. But I should say in the past, it didn’t matter if the prior year was 1% inflation or 3% inflation, they were always going to gun for 2% inflation the next year. Now, you spent some time at 1%. I don’t know that you can quite say they’re therefore going to target 3%, and make it perfectly even, and 2% is the average throughout, but they’re going to tolerate a little bit more. And so that’s really the big takeaway, and it does suggest we could get a little more inflation down the line. I suspect the real story is one in which they’d be perfectly happy just to get to 2% and don’t feel they absolutely need to go above. But one of the tricks in the central bank toolkit is when inflation is quite low, you have to raise expectations. That can actually be a self-fulfilling prophecy. And so if you make people think, hey, maybe it’ll be 2.5% in a few years time, maybe they’ll actually get to 2%, which would be a pretty good outcome for them. And as well, as I mentioned earlier, there’s this other kind of more obscure property. Where in future crises, if credible, you go into a recession, your inflation goes down, in theory, markets should be expecting more inflation later because it’s low now. So actually, in theory, their inflation-adjusted rate should be actively falling, even when they can’t cut it any further. So they like that, too. But that’s a bit of a trickier concept. And so that’s the change. I suspect in the end, if anything, we could get a little more inflation at a minimum than previously assumed. We’ll see if they actually get to 2% and beyond, but they’re targeting a little bit more. But I should emphasize, this doesn’t in any way resemble the 1970s or 1980s. Nobody wants 10% inflation. I think they’d be happy to get 2.5% inflation for a few years time. And so that can trickle through into perhaps bond yields over time. It does have implications in other places. But it’s all in all fairly manageable, and it seems fairly reasonable as well in terms of this change that they’ve made. But don’t get me wrong, it is a notable shift after decades of targeting that 2% number at all times.

Well, I’m glad you referenced this isn’t the 70s again. And it may even be a challenge for them to get inflation to that 2% target, let alone getting it to go past. Because I’ve read so many articles, and I’ve had so many people send me emails talking about the potential for inflation. Given all of the debt that’s been accumulated by governments, all the money printing that’s gone on, expansion of the balance sheet of the Federal Reserve, etc. All these are reasons why you might have more inflation in the future. And at least in the near term anyways, that’s not something that is a huge concern to you, I’m getting from your comments?

That’s right. I don’t disagree with the idea that there are things that weren’t there six months ago, that do make an argument perhaps for a bit more inflation. Including this very thing we’ve just been discussing. But put it into context: we’ve been on a practically 40 year downward trend for inflation to begin with. We haven’t really established that we can fully stabilize inflation here, let alone significantly revive it. It’s been falling since the early 1980s. So that’s one thing to keep in mind very much, I think. Let’s appreciate that there is still what appears to be a profoundly deflationary force at work, and that would be some of the demographic influences. The classic Japan example, of an older country having trouble running inflation, and then suddenly Europe is now the next oldest place. What are they having trouble doing? They’re also having trouble running inflation. And so let’s not forget about that. That’s still there. And if you ask almost anyone, including me six months ago, “What do you think the risks lie for inflation over the long run? Probably we would have said the risk is inflation undershoots where it would ideally be, as opposed to overshoots. And so I do recognize, as you just mentioned, yes there is more public debt, and that can create a bit of a temptation to allow more inflation. Central banks are certainly doing a lot of stimulus, a change of mandate that we’ve just discussed. Even some onshoring; those can be inflationary things. It’s not yet clear whether those can outmuscle the demographic downtrend. And for that matter, let’s appreciate that very few of those things would benefit from outright high inflation. You could see a greater tolerance for 2% and 2.5%. And who knows, maybe there’s a 3% out there somewhere. But public debt levels don’t get helped if you run high inflation. That actually creates big problems. And central banks, yes they have big balance sheets, and they’ve done a lot of stimulus. But with an eye towards achieving 2%, or now slightly above 2% level. Nobody’s trying to make hyperinflation here. And the onshoring story, much as globalization did, put some downward pressure on inflation. But it wasn’t the whole story. There’ll be some upward pressure, but it’s not the dominant thing. So for the moment, we’re in the middle of a demand shock. I mean, unemployment is high, no one’s screaming for wage increases, companies can’t jam through price increases. We’re not seeing a lot of inflation now. It’s hard to fathom there being an inflationary problem over the next year or two. Conceivably beyond there, a little bit more trickles in. But again, probably a pretty tolerable amount. Just as running a little below 2% didn’t end the world over the last decade, running a little above 2%, if achieved, doesn’t end the world either. It’s probably a pretty tolerable thing. And it’s, again, not even clear this will be fully achieved.

Yes, and it’s always an important reference for people of my age and a little bit older, those of us who lived through the 70s and remember the high inflation back then. And now, who are moving into retirement, or already in retirement. High inflation: bad thing. But moderate inflation, or a little bit of inflation is actually something you need and you want in an economy. And that’s what we’re talking about here. And such an important point. So, Eric, thank you for clarifying all that. I know a lot of people might have seen that in the news, and were wondering exactly what it meant. And you put it in perfect context, as always. Great to have you on again, and I look forward to having you on again soon. Eric, thanks.

Clear as mud! Thanks a lot Dave.

Perfect. Take care.

Disclosure

Recorded September 23, 2020

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