The Federal Reserve announced on Thursday, Aug. 27, that it has adopted a new strategy for monetary policy that will be more tolerant of temporary increases in inflation.
Basically, the new approach will allow inflation to overshoot the US central bank’s 2% target to compensate for persistently low inflation, which has been weighing on the US and other economies in recent years.
Following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 per cent for some time,” Mr. Powell said.
He said such a low inflation scenario would be “costly” in slowing the recovery from the pandemic, and “risky” because “a longer phase of even lower inflation might become entrenched and contribute to a downward drift in inflation expectations.”
As we all know, the Federal Reserve has full control over short-term interest rates, and the interest rates the banks can borrow overnight, but long-term interest rates are determined by Mr. Market, or by investors. This means that if inflation starts ticking up, then the yield curve will start to widen more significantly than previous cycles because the Fed will allow some flexibility before intervening.
With his statement Powell effectively means that: The Fed will keep interest rates at ultra-low levels for years to come.
What Lower For Longer Interest Rates Mean
There are several ramifications of keeping interest rates lower for longer. I will list some of them:
1 - Higher Stock Prices
Stocks will be one of the biggest beneficiaries as a result of lower interest rates. There are many reasons for this:
- Interest rates on CDs and shorter-term Treasuries will remain near zero. This will cause more savers and retirees to allocate a larger part of their portfolio to equities.
- Leverage and margin costs will remain
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