Last week’s speech1 from Federal Reserve Chair Jerome Powell could mark a critical break from three decades of central bank behaviour. Jupiter’s multi-asset team explain why investors need to be prepared for the consequences of a leap into the unknown.
A structural shift of reaction function
Central banking as we know it hasn’t been around for all that long. The Federal Reserve was founded in 1913, nearly 250 years after the first central bank in Sweden. The second oldest, the Bank of England, only gained full independence aged 303, in 1997. After the post-war period ended in the trauma of 1970s stagflation, the principal target of central banks has been to control inflation; and beginning with Chairman Paul Volcker, under whose leadership interest rates peaked at 20% in 1981, they’ve been enormously successful.
Since the last crisis, the challenge facing central banks has inverted: the principal problem now is the lack of inflation. This is despite the development of a wide range of “extraordinary” new tools: zero interest policy or ZIRP, forward guidance, QE, operation twist, SMCCF2, to name just a few. The lesson of the recent past for Chair Powell, echoed by Governor Brainard3 a few days later, is that a much lower level of unemployment can be achieved without inciting inflation than previously thought. The fear of inflation as the primary restraint on monetary stimulus has drastically reduced. The Fed’s hands are untied.
Last week’s announcement of Flexible Average Inflation Targeting (FAIT) was part of this acknowledgement that the Federal Reserve will do whatever it takes to deliver full employment, even if it means inflation being above the 2% target for a period of time. This is a significant change to the Fed’s interpretation of its mandate. While there are many that will look – with good reason – to the significant deflationary pressures out there, for us the key takeaway is that this announcement frees the Fed to keep its foot on the gas for much longer than it could previously. This is a big change, and a leap into the unknown.
The inflation debate
We argued in April that the pandemic had caused a deflationary shock to the global economy but there were reasons to believe that inflation could return in the longer term.
For the short to medium term we are still in a profoundly disinflationary regime. Long term factors are behind this: central bank success in controlling inflation, ageing populations, low productivity, globalisation (increasing labour supply and outsourcing), technological disruption. The pandemic has caused a massive demand shock. Yet there are structural reasons that can drive inflation higher over the longer term. The retreat of globalisation, making China less able to export deflation round the world, and as companies look to renationalise supply chains, can potentially put upward pressure on costs and prices. Insolvencies from the crisis can lead to better pricing power for the survivors.
This is the first time that fiscal and monetary policy have been pushing in the same direction for many years. There is little appetite for a return to the years of fiscal austerity. Consumer inflation expectations are key: If employees are happy to accept lower wages in return for keeping jobs, we risk a deflationary spiral like that in Japan from the 1990s onwards. Conversely, in many instances fiscal transfers have boosted disposable income above pre-crisis levels and could help to facilitate a rise in inflation expectations. Public opinion may also pressure governments into wage rises for key low-paid sectors of the economy.
One of the major concerns for many investors when thinking about the medium-term consequences of the pandemic is that a wave of insolvencies will severely impair the banking system and prevent credit flowing to the real economy. We agree that the economic consequences of the crisis are likely to be with us for some time. However, the banking system is far better capitalised than it was in 2008, and government support via credit guarantee schemes reveals that banks are being seen as part of the solution this time round. This gives us more confidence that the supply of credit will not weaken materially enough to have a deflationary effect.
Why does Chair Powell’s announcement matter?
No-one can say for sure whether the forces of inflation or deflation will win out, when or by how much. What’s crucial about this development is that the Fed is significantly less constrained in keeping liquidity flowing into markets than it used to be. This will materially alter the balance in favour of higher inflation in the longer term. For the short term, the key conclusion is that this is a significant change to the Fed’s interpretation of its mandate and represents a leap into the unknown.
Chair Powell’s speech (echoed by Lael Brainard a few days later) makes it clear that the lessons learned from the past few years are that the economy can sustain a higher employment level than previously thought without risking inflation (effectively admitting that 2018’s rate hikes were a mistake), and that the benefits of higher employment were beginning to be shared more widely across society. In addition, higher inflation is the easiest way to bring debt levels down. The benefits of lower unemployment and moderately higher inflation are fixed in the Fed’s mind, and they have changed their mandate to try to achieve it.
What does this mean for investors?
There are short-term consequences that we can already see happening. Real interest rates (interest rate adjusted for inflation) at less than -1% are at all-time lows. The dollar has depreciated significantly, US Treasury yields have sold off and curves have steepened across the globe.
Over the longer term, if the Fed succeeds with FAIT and economies can break out of the disinflationary trend these consequences can be profound. A likely loser is Europe: the European Central Bank doesn’t enjoy unified political support or have anything like the Fed’s freedom of action at the moment, so the euro can continue to strengthen. Therefore, on a relative basis we continue to prefer US equities in the strategy, driven by ample US policy accommodation. A weaker dollar is supportive for more cyclical Asian markets, so we have added exposure.
Within markets, can reflation start to unwind the long-term trends that have dominated equity markets? Very low real rates have supported quality, growth companies (especially in technology) for a long time now. The pace of outperformance for these companies has slowed over this summer, but we think it’s too early to call for a reversal, and note that there are other structural forces behind the strength of technology in particular. We therefore continue to have a quality/growth bias to the strategy, but a more moderate one, and we aim to add more cyclicality where we can find it for the right price. Finally, ongoing accommodative policy and the threat of inflation can continue to support the price of both precious and industrial commodities.
The inflation debate is finely poised, and investors will continue to debate the competing strengths of deflationary and inflationary forces. Our key takeaway is that this subtle change to the Fed’s mandate changes the game, and could represent the first real structural shift in Fed behaviour since 1980. This is a leap into the unknown that will require flexibility and adaptability as it develops.
Market and exchange rate movements can cause the value of an investment to fall as well as rise, and you may get back less than originally invested. The views expressed are those of the individuals mentioned at the time of writing are not necessarily those of Jupiter as a whole and may be subject to change. This is particularly true during periods of rapidly changing market circumstances.
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