HedgeTalk: Did the Federal Reserve Just Promise Low Rates Forever?
By: John Trefethen, Director & Co-Founder
Late last week the Federal Reserve (the “Fed”) decided to drop its practice of manipulating interest rates to manage its stated goal of 2% inflation. This decision is a major shift in how the Fed sets interest rates - a move that will likely leave US borrowing costs historically low for an extended period of time. Fed chairman Jerome Powell called the strategy shift a “robust updating” of Fed policy.
The Fed has enacted a policy of “average inflation targeting", though the inflation target will remain at 2%. Historically, the inflation target of 2% was viewed as a ceiling. Under the new policy, the Fed will allow inflation to float above 2% following periods when it has lingered below its stated goal, and vice-versa. Picture an inflation-based teeter-totter with the targeted 2% average inflation rate at its fulcrum.
For many years the Fed adhered to the Phillips Curve, an economic theory that states that inflation and unemployment have a stable and inverse relationship. In the past, the Fed has attempted to proactively head-off inflation by raising interest rates whenever it thought the unemployment rate was getting too low. In theory, less people in the labor force means less consumer spending, which leads to lower inflation.
The change in policy means that the Fed won’t be in a rush to raise interest rates even if inflation starts to pick up as the US recovers from the COVID-19 pandemic. However, underscoring the Fed’s policy change is the fear of the US falling into a deflationary spiral similar to what Japan has experienced. Periods of deflation can be difficult to reverse for central banks because they become a self-fulfilling prophecy – as prices begin to fall, consumers tend to hold off on purchases waiting for prices to fall further.
Both borrowers and lenders will need to consider the policy change, and the likelihood that interest rates will remain low longer than expected, as they consider future borrowing and lending activity. Because of the zero-sum nature of hedging, hedging strategies exist for both borrowers and lenders that will allow borrowers to take advantage of the extended low rate environment, and lenders to manage the risk that they will experience in that same extended low rate environment.
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