INSIGHTS

The minutes from the latest US Federal Reserve meeting contained a very interesting paragraph. Near the middle of the 8000-word summary was a subtle clue about a potential change in tack.

The Fed said a “temporary period of inflation modestly above two per cent” would help meet its inflation objective and anchor longer-run expectations.

We don’t know exactly what temporary means, nor do we know what the Fed considers modest. However, financial markets will be very keen to find out.

For most of the last decade the central bank has failed to meet its two per cent inflation target, despite the lowest interest rates in history and a phenomenal amount of stimulus.

Because of this, the Fed is getting more comfortable with letting inflation run higher than its target for a while to make up for the long period of undershooting.

The popular rhetoric is that the US economy is back on track, inflation will follow and the Fed will continue raising interest rates in response. That will add to upward pressure on the US dollar, tightening financial conditions even further.

Eventually, this combination of higher interest rates and a stronger greenback will choke off the recovery, push the US into recession and derail the current optimism in global markets.

But what if the Fed is happy to let inflation go higher for a while, and doesn’t feel the need to stamp it out right away?

A less aggressive path for interest rates would almost certainly drag the current economic expansion out for a while longer, and it would mean less upward pressure on the US dollar. Both of those things are positive for global growth, as well as corporate profitability and share prices.

I wouldn’t be surprised if the Fed proceeded in exactly that manner. Like most central banks in the developed world, I suspect the Fed is far less worried about inflation than the prospect of a return to the deflationary risks of a few years ago.

Paul Volcker proved central banks can deal with inflation. Volcker was Chairman of the Fed from 1979 until 1987. In the first year of his tenure inflation hit 14.8 per cent, so he cranked interest rates up to 20 per cent in response.

That took its toll on the economy and pushed unemployment to over 10 per cent. He made plenty of enemies along the way, but he beat inflation. It was below three per cent by 1983 and the US economy rebounded to enjoy a very strong expansion during the rest of the decade.

Deflation, on the other hand, still gives central bankers nightmares. Japan has been trying to drag itself out of that hole decades, while the US and Europe have thrown the kitchen sink at low inflation with little success.

Maybe the conventional thinking is right. Inflation might return, US interest rates could head a lot higher and a recession may be on the cards within a year or two. Then again, this cycle has been anything but conventional and the Fed might adjust its thinking accordingly.

We shouldn’t forget about the fiscal stimulus coming for the US economy either. Generous tax cuts are now in place and a big infrastructure package is potentially on the way. Whatever path the Fed takes, that fiscal easing will offset the monetary tightening to some degree.

If you’re the glass half full type and you’re looking for a bull case, maybe this is it.