The Fed changes how it looks at inflation

On 27 August 2020, at the Jackson Hole symposium, the Federal Reserve announced it would target average inflation of 2%. The change allowed interest rates to stay low even if prices rose for a while. It was a technical adjustment in how the target is defined, but with practical consequences for the cost of money in the United States and, by extension, in the rest of the world. That is why it is a matter worth following even when the central bank is not one’s own.

Although the decision was taken in a specialist forum, its importance reached companies and families far removed from Wall Street. The Federal Reserve’s policies influence interest rates, the value of the dollar and the risk appetite of international investors. Understanding the change helps to interpret the low-rate environment and to anticipate how it might evolve, although nobody can be sure. The prudent course is to prepare for several outcomes.

What changed in the target

Until then, the Federal Reserve had pursued 2% inflation. Under the new approach, it would aim for inflation to average 2%: if it had been below for a while, it could let it run somewhat above. It was a change of method announced at the Jackson Hole symposium.

The difference seems subtle, but it has implications. A fixed target pushes the central bank to react as soon as inflation approaches 2%, whereas an average target gives it room to wait. If inflation had been below for some time, it could allow it to rise a little further without immediately tightening policy. In practice, this meant more tolerance for rising prices and, therefore, more time with low rates. This flexibility was new compared with the traditional way of conducting monetary policy.

Why it matters for rates

This approach allowed rates to stay low even if prices rose for a while. For anyone with a mortgage or variable-rate debt, that was good news in the short term. For savers, it meant that returns on the most conservative products would stay low for longer.

Each household and each company stands differently before this reality. Someone with variable-rate debt benefits from moderate instalments, but is exposed to possible future rises; someone saving in conservative products sees their capital lose purchasing power if prices rise by more than the return. Reviewing one’s own position, debt and savings, is useful to know which side one is on. The terms of each contract, such as maturity or spread, determine how far a change in rates really affects it.

A decision with consequences

It was a technical change with large consequences: two years later inflation would surge and rates would rise at a pace not seen in decades. It is worth remembering that central bank policies have effects over the medium term. Anyone taking decisions on debt or savings should consider what would happen if the rate scenario changed.

A simple stress test is to ask how much the instalment on a variable-rate loan would rise if rates became markedly dearer, and whether the household or company budget could bear it. For savings, the question is how much purchasing power would be lost with higher inflation. With the answers, the adviser can set out options, such as fixing part of the debt or reviewing the structure of savings, without recommending anything before knowing the case. The point is to prepare scenarios, not to guess the future.

Today’s decisions on interest rates shape the cost of debt tomorrow.

This article is general information. It is not legal, tax or investment advice, and it does not take anyone’s particular circumstances into account.