Eye-catching distractions are everywhere. But, despite volatility in the financial markets, investors and traders need to ensure they haven’t overlooked a monumental policy change enacted recently by the United States Federal Reserve.
The Fed’s recent shift affects what is commonly referred to as the “dual mandate”—the twin responsibilities of the Fed to maintain low inflation and low unemployment in the domestic economy.
The Fed announced on Aug. 27 that it would loosen control over inflation in favor of maximizing employment—at least in the near term.
This revelation is especially significant when one considers that interest rates have plummeted to record lows, while unemployment has spiked toward record highs. The extreme conditions presented by a pandemic-stricken economy apparently warrant extreme measures.
Technically speaking, the Fed plans to achieve this policy shift by adjusting the method by which its inflation target is calculated. The annual inflation level targeted by the Fed has traditionally been 2%.
A key to understanding the reasoning behind the Fed’s policy change relates to the historical inverse correlation that exists between interest rates (i.e. the federal funds rate) and the unemployment rate.
When economic growth slows, the Fed traditionally lowers interest rates in order to catalyze increased borrowing from businesses and consumers. That, in turn, typically leads to increased investment in the economy and a return to growth.
One can see how lowering interest rates has the indirect effect of increasing employment.
One potential complication with this approach is that the economy grows too quickly and begins to overheat. Under that scenario, prices can increase too quickly, stoking unwanted inflation, and potentially inflating new asset bubbles. That type of overshoot can force the Fed to raise interest rates too quickly, which can stifle hiring.
The dual mandate therefore represents a high stakes balancing act with maximum employment on one end and stable inflation on the other.
Going forward, however, the Fed will place the mandate to maximize employment above the mandate to control inflation—to a small degree. As of Sept. 1, the method by which the Fed calculates its 2% inflation target will be averaged over a longer period of time.
That means that if the U.S. economy spends an extended period in a recession or depression, the Fed will theoretically act more slowly in raising interest rates as economic conditions normalize.
In terms of the technical methodology, the key lies with the fact that during a recession or depression, inflation tends to drop below 2%. Since the Fed will now be targeting a 2% average over a longer window of time, that means the country’s inflation rate will need to spend some time above 2% during the recovery, which means the Fed will have more flexibility to hold off on raising rates.
While the full implications of this policy adjustment won’t be known for some time, there are some immediate implications, particularly for investors and traders. The Fed has essentially announced that it will allow inflationary conditions to exist for a longer period of time, relative to past economic crises.
Based on current inflation data, the Fed may have been required to start raising interest rates relatively soon—at least according to the old methodology. With this change in place, the risk now swings toward the other end of the spectrum: too much inflation.
Leaders at the Fed have apparently decided that getting the economy back to full employment—or at least as close as possible—is of much greater consequence than too much inflation.
Depending on one’s particular market outlook, strategic approach and risk profile, that stance could make inflation-focused trades/positions/exposures relatively more attractive for investors and traders going forward.
One of the most popular inflation trades has traditionally involved precious metals, and more specifically, gold. This is because inflationary conditions tend to push down the value of the local currency (i.e. the dollar), meaning more dollars will be needed to purchase the same amount of gold as inflation intensifies, everything else being equal.
Interestingly, these are the exact trends that have been observed in the financial markets of late: rising gold prices against the backdrop of a wilting U.S. dollar.
Sage Anderson is a pseudonym. The contributor has an extensive background in trading equity derivatives and managing volatility-based portfolios as a former prop trading firm employee. The contributor is not an employee of luckbox, tastytrade or any affiliated companies. Readers can direct questions about any of the topics covered in this blog post, or any other trading-related subject, to email@example.com.