Macro (Re)view (28/8) | Shift in the policy regime

This week's virtual meeting of central bankers for the Jackson Hole Symposium was headlined by the unveiling of the shift in the Federal Reserve's monetary policy framework. A more than 18-months-long review conducted by the Fed into how it uses its tools and communicative strategies to meet the objectives assigned to it by the Congress has formalised a revamped approach to monetary policy decisionmaking and this is likely to be a sign of things to come for other central banks across the globe. How this is to be carried out remains unclear, but what markets were told was that the Fed's reaction function has changed. Previously, a key factor influencing the Fed's conduct of monetary policy was the linkage between the level of unemployment and the rate of inflation. The conventional thinking being that a tight labour market would ultimately lead to the economy overheating, thereby encouraging inflation to rise to a level above its target (2%). However, despite the labour market tightening progressively over the years that followed the GFC, inflationary pressures never sustainably took hold, neither in the US nor in other economies across the globe. The emergence of the pandemic crisis has since upended labour markets and led to disinflationary pressures overall. The key message in the speech delivered by Federal Reserve Chair Jerome Powell was that monetary policy will now be set in such a way that will encourage the economy to strengthen, without being as sensitive to the prospect of rising inflation as before.

Mindful of the damage inflicted on society through the dislocation to the labour market caused by the pandemic, Chair Powell effectively signaled that its reaction function will now give greater prominence to its maximum employment objective. To that end, the Fed's framework now states that policy decisions will be guided by "shortfalls of employment from its maximum level". The Fed will not be tied to nominating a targeted level for the unemployment rate, but it will seek to drive it down until it sees clear signs that longer-run expectations of inflation are moving to uncomfortably high levels (i.e. above its 2% target). It is this focus on expectations for the future level of price increases that facilitates the Fed's move to a regime of average inflation targeting. The Fed will now have the flexibility to consider earlier periods of too-low inflation and set monetary policy to encourage inflation to be "moderately above 2 percent for some time". Distilled simply, its price stability objective is now to "achieve inflation that averages 2 percent over time". More detail on how the Fed now sets about achieving its objectives will be expected by the markets at the September FOMC meeting, with a more explicit form of forward guidance and greater clarity on asset purchases in the mix to be announced.

The European Central Bank was also represented at the Jackson Hole Symposium in which its Chief Economist Philip Lane presented a speech outlining the importance of its pandemic emergency purchase programme (PEPP) in stabilising markets, keeping the supply of credit available and in warding off downward risks to inflation expectations following the onset of the crisis. The implementation of the PEPP was seen as key in transmitting an easing in the Bank's monetary policy stance by narrowing sovereign yield spreads across the euro area, in turn lowering borrowing costs for governments, businesses and households. Lane discussed that the ECB saw its response to the pandemic as consisting of two stages; the first was to address the immediate shock through an aggressive easing in monetary policy and the second, which is where it is currently, is to ensure policy settings remain calibrated to be consistent with inflation expectations converging back to its target, and it thus keeps on the table the option to make further adjustments as deemed necessary. The importance of fiscal policy in responding to the crisis was also emphasised and to that end, the announcements by the national governments in Germany and the Netherlands this week to extend the duration of their wage subsidy schemes would have been welcomed by the ECB.   

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Switching to domestic events, updates on construction activity and capital expenditure for the June quarter were released by the ABS ahead of next week's national accounts, which are likely to report a sizeable contraction in GDP of around 6-7% to reflect the full scale of the impact of the national shutdown from late March to mid-May (preview here). Construction work done declined by a relatively modest 0.7% in the June quarter against an expected fall of 7.0% (see here). The ABS noted that with the construction sector being designated as an essential service, work was still able to progress around the social distancing restrictions. The surprise in the report was the composition of activity, with a sizeable decline in public sector works of 3.2% (-0.4%yr) while construction work by the private sector proved more resilient coming in flat at 0.1% (-2.2%yr), though the detail varied considerably. Engineering work lifted sharply rising by 8.6% in the quarter that appeared to be linked to increased levels of mining-related investment after several years of contraction. Meanwhile, the downturn in the residential construction cycle intensified as new home building contracted at an accelerated pace of 5.6%q/q to be down by 13.6% through the year — its sharpest rate of deterioration in nearly two decades. Commercial (non-residential) construction activity declined modestly in Q2 (-0.7%) but is likely to weaken further as firms cut back investment spending amid a weak and uncertain economic climate.

To this point, private sector capital expenditure fell by 5.9% in the June quarter to $26.13bn to its lowest level since Q3 2007 (see here), though a larger decline of 8.2% had been anticipated by markets. The emergence of the pandemic accelerated earlier weakness in investment in the non-mining sector falling by 8.0%q/q (-17.3%) and in the main this was driven by services industries (-8.4%q/q, -18.6%yr). Capital expenditure by the mining sector softened in the June quarter (-1.2%) but remained higher over the year, likely reflecting work on iron ore-related projects. In addition to the broad-based falls in actual capital expenditure, the report also contained significant downgrades for forward-looking investment plans. The 3rd estimate of total capital expenditure plans for 2020/21 put forward by domestic firms to the ABS during July and August was nominated at $98.6bn, indicating that investment was on track to decline by 12.6% compared with the same stage for the previous financial year. Three months earlier, capital expenditure plans pointed to a smaller year to year decline of 8.3%. The downgrades were led by the services industries, with capital expenditure now projected to fall by 20.4% over 2020/21 (from -18.7%), with manufacturing to also weaken at a faster pace of 11.8% (from -7.2%). Meanwhile, the projected upturn in the mining investment cycle flattened sharply to point to a 0.6% rise through 2020/21 from an implied 10.2% lift three months ago (see chart of the week, below).  

Chart of the week

Further context was provided to Q2's capital expenditure report through the ABS Business Impacts of COVID-19 survey for August (see here). The survey reported that nearly 1 in 4 firms had already reduced or planned to reduce capital expenditure plans compared to 3 months ago, with the most influential reason mentioned being due to uncertainty over future economic conditions.