What does average inflation targeting have to do with investors?

One of the responsibilities of the United States Federal Reserve is to maintain price stability over a long period of time. In other words, it’s the Federal Reserve’s job to see that there is no lack of inflation or deflation along with prices as the economy evolves. This is important because failing to meet the inflation target translates into less spending, which leads to business failures and job cuts.

According to the Federal Open Market Committee, “Inflation at the rate of 2 percent, as measured by the annual change in the price index for personal consumption expenditures, is most consistent over the longer run with the Federal Reserve’s statutory mandate. The Committee would be concerned if inflation were running persistently above or below this objective.”

However, the Federal Reserve has been struggling to reach its goal of a 2% inflation rate, largely due to COVID-19, so it is rethinking its strategy to achieve price stability again.

Its solution? Average inflation targeting (AIT).

What is average inflation targeting?

Recently, the Federal Reserve has confirmed that it is implementing a policy to introduce AIT with the objective of reaching an inflation rate that averages 2% over time. While it has not specified exactly how it will achieve this goal yet, the essential concept is that the Federal Reserve will allow inflation to exceed 2% for a period of time to make up for the periods of time that failed to reach 2%.

This contradicts the usual method of keeping inflation at a fixed target level by raising rates to bring the rate of price increases back on target. However, because of the recent stumped growth of inflation, the Federal Reserve is going outside of its comfort zone.

While this change brings an amount of the unknown with it, Americans can be comforted by the fact that New Zealand had success with a similar policy in the 1990s and the UK had similar success shortly after. 

How does average inflation targeting affect investors?

Initially, the market can be viewed as bearing as the Federal Reserve targets an inflation rate higher than 2%. This is because yields on longer maturity bonds rise more than yields on short maturity bonds. For example, in August 2020, bonds maturing over 30 years rose from 1.20% to 1.45%, which indicates that markets expect the rates to be higher over the long term as the economy grows and prices stabilize. This is precisely the goal of AIT.

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