What a more flexible Fed means for investors everywhere
Do changes at The Fed mean low rates forever?
The Fed, America’s central bank, has a dual mandate, to maintain stable prices for the goods and services that households want to purchase, and promote maximum employment, which means that everyone who wants a job can get one. Congress formalised this mandate in 1977, but the Fed has been guided by it since the 1946 Employment Act, passed to help ensure Americans were rewarded for their efforts during World War II with a good standard of living.
This August, Fed governors made a once-in-a-generation change to the way in which they interpret this mandate, and the strategy with which they will pursue its goals. We had been anticipating part of the change since the Fed started dropping hints in the summer of 2019 (and so had the market in recent months), but the new statement means that interest rates will likely stay very, very low for even longer than previously thought acceptable.
Why did anything need to change at The Fed?
The Fed’s transparent inflation-targeting framework as we know it today was established for the most part in the 1990s. Since then, the Fed has observed that:
— potential economic growth has declined significantly, particularly trend productivity growth, which has more than halved since the late 1990s;
— the neutral real interest — the rate consistent with the economy operating at full strength and with stable inflation, and not directly affected by monetary policy — has fallen with it;
— despite extremely low unemployment, inflation has been stubbornly low over the last business cycle (figure 4); and
— global disinflationary pressures and low longer-term inflation expectations, an important driver of actual inflation, may have been holding down inflation more than was generally realised.
Those observations are a big problem for policymakers. Inflation that runs persistently below its desired level can lead to a fall in longer-term inflation expectations, which, in turn, can pull actual inflation even lower, resulting in an adverse cycle of ever-lower inflation and inflation expectations. If inflation expectations fell persistently, interest rates would decline in tandem, and with interest rates already low the Fed would have less scope to cut interest rates to boost employment during an economic downturn, which could further lower expectations and trigger a vicious circle.
In other words, the Fed doesn’t want to fall into the trap Japanese policymakers found themselves in during the 1990s. Of course, central banks have developed new tools to fight deflation when interest rates are near zero, such as using their balance sheet to buy bonds (quantitative easing). Over the last decade these extraordinary measures have been very effective, but Fed staff are the first to admit that they aren’t entirely clear how. Far better to try to engineer a situation in which there is less recourse to them.
A more flexible approach to interest
So, what have they done? They have adopted a flexible average inflation targeting (AIT) framework. The Fed still wants to facilitate a 2% annual rate of inflation, but on average, not necessarily year after year. Following periods when inflation has been running below 2%, which have become uncomfortably common, monetary policy will aim to achieve inflation moderately above 2% for some time in order to make up for the shortfall. Note the asymmetry. If inflation averages above 2% for some time they will not target below-2% inflation to bring down the average. They’ve given themselves plenty of leeway: details of the “make-up” period have been left out of the policy statement. A chart that the Fed used last year indicates what this could mean for the path of policy rates: in mid-2019, interest rates were 2.25%, but if the Fed had been following a rules-based form of AIT, interest rates should have been 0.1% instead.
On employment, the revised statement emphasises that “maximum employment is a broad-based and inclusive goal” and “the benefits of a strong labour market, particularly for many in low- and moderate-income communities.” We note asymmetry here too. They are now driven by “shortfalls of employment from its maximum level” rather than by “deviations”. In other words, because the Phillips curve (the relationship between unemployment and inflation) appears to have flattened considerably, the Fed will no longer necessarily tighten rates when unemployment is back to normal, because there is evidence that this would mean women or minority communities may miss out on employment gains.
We note one more change that few people seem to be talking about. The new statement explicitly addresses financial stability and elevates it in the hierarchy of the Fed’s goals. That’s because long expansions, fuelled by low interest rates, are more likely to result in destabilising pockets of financial largesse. This change signals that the Fed will likely make more use of so-called macroprudential policy tools (eg, minimum capital requirements for commercial banks and similar restrictions).
While most investors accept that we are never returning to the lackadaisical days of pre-crisis regulation, we have been doubtful for some time that many really appreciate that regulation is likely to get tougher still. In our opinion, a better buttressed financial system is no bad thing when the greatest threat to investment returns is a deep balance-sheet recession. In capitalism’s “golden age” of 1948—72, economic growth was so strong because there was no deep recession, in part achieved by institutional reforms which promoted financial stability and long-term thinking.
Changes have impacts on more than just money
Some investors are already worried that the extraordinary increase in money creation to fund stimulatory measures during the COVID economic shock will unleash rampant inflation. This dovish turn in the Fed’s approach may alarm them further. We don’t believe that sustained high inflation is a big risk, as we set out in a recent InvestmentUpdate. In short, the money supply has risen as part of the effort to plug a profoundly deflationary hole caused by this year’s economic dislocation and the increased desire to hoard savings. But if inflation does start to rise, it will now have to last for a period of years before the Fed is prompted to try to curb it. And if rising inflation expectations start to push up longer-term borrowing costs, we may actually see the Fed respond with policy measures to push those costs back down so that they don’t choke off the expansion before low-income households have participated in it.
It’s also worth considering the inflation implications of any structural shifts that COVID might be a catalyst for. Most of the ones we can think of — for example, greater shifts from the physical to the digital economy or moves away from city-centre commercial real estate — are mildly disinflationary.
Taking all these factors together, we are more concerned about the risk that inflation remains stubbornly low than we are about it becoming intolerably high. Inflation is about more than central bank money. With spare capacity in the economy (figure 5) and incentives for companies and households to hoard cash, inflation should remain subdued.
This means any cyclical investments that tend to rely on rising yields, such as many banks or ‘value’ stocks, may be waiting a long time for any sustained outperformance. Meanwhile, an even longer period of repressed bond yields, which are used to discount company earnings into today’s prices, helps support the high valuations of equities with strong growth credentials.