The Fed – Allowing the economy to run hot

About the author:

Michael Knox
Author name:
By Michael Knox
Job title:
Chief Economist and Director of Strategy
Date posted:
10 February 2021, 11:39 AM

I spoke to the Morgans network about the way the Federal Reserve now looks at inflation targeting.


On 24 January, the Fed released a document called “Statement on Longer-Run Goals and Monetary Policy Strategy”. In this document, it provided details of the way it was now going to approach inflation targeting.

Instead of simply targeting an inflation rate, they were now going to target the average of that inflation rate over time.
The Statement read that the Fed reaffirmed its inflation target at 2% measured by the personal consumption deflator.

What was new was the statement that "following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time". This is so the Fed achieves an average 2% inflation target over time.

After the Fed meeting on 27 January, Chairman Jay Powell, noted that "the committee seeks to achieve maximum employment and inflation at the rate of 2% over the longer run. With inflation running persistently below this longer run goal, the committee will aim to achieve inflation moderately above 2% for some time so that inflation averages 2% over time and longer-term inflation expectations remain well anchored at 2%”.

He went on to say that the committee expects to maintain an accommodative stance of monetary policy until those outcomes are achieved. We think that this means the Fed will allow the economy to “run hot”.

In the Fed meeting of 16 December, the Summary of Economic Projections suggested that US GDP would grow by 4.2% in 2021. This would be followed by 3.2% in 2022. They further suggested that US unemployment would fall to 5% at the end of 2021 and 4.2% at the end of 2022.

What is interesting about achieving 4.2% unemployment at the end of 2022, is that the Fed’s estimate for the longer run average level of unemployment in the same document, is now 4.1%.

This 4.1% must be taken as the Federal Reserve’s estimate for the natural rate of unemployment.

Unemployment must fall below this level before the US economy can begin to generate sustainable levels of high inflation.

In the Fed outlook, we can only begin to enter this period in 2023. In that year, the Summary of Economic Projections suggested that US unemployment would fall to 3.7%.

Inflation rises with a lag when unemployment falls below the natural rate of unemployment. This means we can only begin to expect this period of above 2% inflation in the US economy to begin sometime in 2024. Even then, the Fed, in its new approach is unlikely to act to slow inflation’s rise.

This suggests we are unlikely to see concerted action by the Fed Reserve to tighten monetary policy before late 2024 or 2025.

The problem with this approach is that the Fed only truly determines interest rates at the short end of the yield curve. As inflation rises in future years, and the Fed Funds rate stays stable, the likely result is a steady rise in long term interest rates. Bond values will begin to fall, burdened by the view that inflation will be higher for some time.

The Fed may intervene in this market, but a bond market is difficult to hold in place, after it begins to fall. It is entirely possible that the Fed’s change of policy, of allowing interest rates to run above the target for an extended period, will generate a future bear market in US treasury bonds.

Bear markets in treasuries are hard to hold and hard to stop.


The Fed has changed its inflation targeting policy to a longer run average inflation rate. The US likely gets back to full employment by 2023. After that, higher inflation may start a bond market bear market which will be hard to hold.


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View more analysis from Michael Knox by clicking on 'economic strategy' in the popular topics list, or listen to his full playlist of podcasts on Soundcloud. Alternatively, contact your Morgans adviser or nearest Morgans branch.

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