The Fed’s new framework still leaves investors guessing

The Federal Reserve’s newly revised long-run policy goals announced this week enshrine a now familiar pattern of investment behaviour: a higher tolerance of riskier assets and higher use of leverage among investors seeking some kind of return.

The shift accentuates the importance of central banks containing future bouts of market turmoil in their efforts to facilitate an economic recovery, and deepens the involvement of central banks in markets, further distorting asset prices and nurturing recurring bubbles.

The message from Jay Powell at the annual Jackson Hole Symposium is that US interest rates will sit in the basement for a very long time, perhaps even well after the central bank reviews the progress of its new framework in five years’ time.

Not only does the US central bank desire a period of consumer price inflation running for an unspecified time above its target of 2 per cent — a goal it has missed for much of the past decade — but Fed policy has also shifted its definition of full employment for the economy. Rather than raising rates once the unemployment rate drops below a certain level, officials will wait until a tight jobs market has begun pushing inflation higher before thinking about tightening policy.

This marks a rebuttal of the Federal Reserve’s efforts in nudging interest rates higher in late 2015, when core US inflation loitered around 1.5 per cent and unemployment was falling towards 5 per cent. In the future, such “pre-emptive” action will stay in the toolbox, until easy monetary conditions fan a much stronger and sustained recovery.

David Riley, chief investment strategist at BlueBay Asset Management, says the signal from Mr Powell “is unambiguous” and amounts to the Fed allowing the “US economy to run ‘hotter for longer’ before it considers raising policy interest rates”.

Just how hot is an important consideration in the next few years. Much rests on whether the Fed’s desire for higher inflation is actively pursued, particularly under any new chair. Mr Powell has unleashed the Fed’s firepower and expanded the range of assets it buys. His successor will probably come under intense pressure to reduce unemployment, which means pushing a lot harder on both monetary and fiscal stimulus measures. He or she will also be under pressure to stop financial conditions tightening too fast due to any surge in bond yields that derails equities and the broader economy.

But the reflation trade remains a work in progress. It may have legs this time, due to the recent weakening tone in the US dollar. That goes a long way to explaining why we have seen gold prices rally to about $2,000 an ounce. But market expectations of US inflation over the next decade, observed through the Treasury bond market, have climbed only to around 1.75 per cent from their nadir of 0.5 per cent in March. That marks a return to January’s level and is in line with the average of the past five years. 

Whether this time is really different is a hot topic. The reliance of central banks on rock bottom interest rates and vast purchases of bonds for more than a decade has failed to stem the disinflationary forces of ageing populations, excess savings and technological innovations that cut costs and hollow out established areas of the economy.

Locking down economies has generated a massive output gap — the difference between the actual and potential output of an economy — alongside a rapidly expanding debt burden for governments and companies. And closing the output gap may become a lot tougher as job losses continue. Elevated levels of unemployment at this juncture have mainly been among lower paid workers in service sectors focused on leisure, retail and hospitality. Next up is the prospect of larger companies in finance and other professional services cutting higher income jobs given a likely focus on slashing costs and paying down debt.

One factor in favour of inflation is that, unlike the fiscal austerity era in the wake of the 2008 financial crisis, this time the Fed and other central banks have a lot more support from government spending.

The longer term bullish investment view is that continued fiscal expansion alongside pro-inflationary central bank policy can nurture a recovery that naturally allows companies and governments to slowly reduce their debt levels. In all likelihood this is a story beyond 2021.

For the Fed, tweaking the policy framework is the easy part. It cannot be sure of success in trying to run the economy hotter, or to prevent bouts of market volatility from derailing any flicker of a sustainable economic recovery. “Time will tell,” as Mr Powell is fond of remarking.

michael.mackenzie@ft.com

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