A flat Phillips curve, changing Fed goals, and asset allocation

Forget all the discussion concerning the Fed listening tours and deep policy review. The Fed policy of inflation averaging around two percent is just the final acceptance that the Phillips Curve is flat. The curve is as flat as a pancake so measuring the natural rate of unemployment does not matter. The same argument can be applied to r-star. There is no current inflation trade-off between employment and inflation. It took some time for policy-makers to accept the empirical flatness, but now it has become operational. 

Any handwringing about the trade-off between unemployment and inflation is now a false dichotomy. In a flat Phillips Curve world, the Fed does not have to worry that pushing for lower unemployment will be at odds with their inflation goal. 

Given that inflation is below 2% and the Fed has not been able to reach their goal for any extended period since the GFC, it is hard to see what they could do to raise inflation. The Fed can try to raise inflation, and markets can get nervous but there is little evidence of any "success" at reaching a target. The current inflation averaging policy just states that if the Fed can even see or get inflation above 2%, it will not react with any sense of urgency. 

What does this mean for asset allocation? 

Inflation reaction - If there is any expectation that the Fed will have a strong inflation reaction function as measured in the past, this view can be discarded. Any link between short rates and economic news is broken. It has been broken for some time, but the current Phillips Curve  solidifies what has been found in more recent market data. In fact, investors can discount any Fed discussion or reaction to inflation. This discounting does not mean investors should be unconcerned about currency debasement which is subtly different from inflation. Debasement means that other currencies and precious metals will be valuable.

Market mechanics focus - However, Fed policy will not be driven solely by unemployment. A growing Fed mandate will be to ensure the effective function of financial markets to provide liquidity and help distribute Treasury debt. A continued high deficit policy is only possible through the smooth functioning of the Treasury market. Liquidity mechanics will be a more important Fed function as the buyer of last resort and smoother of debt market volatility. The Fed will continue to be the dominant player in Treasuries and other debt markets. We will see more policy action solely based on market mechanics as opposed to macro fundamentals. This focus is the next step in macro prudential policies.

Fiscal policy ascent - The role of fiscal policy will dominate monetary policy which will focus on ensuring that fiscal policy can be executed. While the inflation averaging policy will mean continued Fed liquidity, the fiscal focus on growth will increase policy uncertainty. An advantage of monetary policy has been its swift response to any crisis. This generally has not been the case for fiscal policy. 

Some observers may feel the new Fed policy is not a change but a clearer representation of current reality, but a codification of reality only means that it will be harder to change in the future. For asset allocation, there is still a clear tilt to risk-on.