Yesterday, the Federal Reserve’s committee for setting monetary policy finished up the first meeting of a new era.
The Fed said that it’s now planning to keep interest rates at zero until inflation “is on track to moderately exceed 2% for some time”.
That’s really quite a big deal. Especially as the Fed currently doesn’t think that will happen until at least the end of 2023, which means rates won’t be rising for at least another three years.
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So why did markets give a big shrug?
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Interest rates aren’t going anywhere for a very long time
The Federal Reserve has been shifting the goal posts on its monetary policy aims for a while now. But now it’s very much official.
The Fed now wants inflation to be above its original 2% target for a while (it’s not specified how long) to compensate for inflation being below 2% for a while. It’s also placing a higher priority on employment than it previously did (again, this is hard to measure, it’s more about emphasis).
In short, the Fed is acknowledging that what economists once assumed about the link between employment and inflation (if employment goes too high, you'll get inflation) isn’t working any more.
So this implies a few things. It implies that monetary policy will be loose – sitting at what we would once have described as “emergency levels”, but is really now just normality – for a very long time indeed.
It also implies that the Fed should be more aggressive in terms of things like quantitative easing and the like. Not just using it for emergency purposes, but also if it feels that inflation simply isn’t rising fast enough.
All of this sounds quite radical, and at one point, it would have been. The kind of thing that not only saw gold, for example, at record highs, but surging a lot higher.
But markets are all about expectations. And by now, when it comes to the Fed, as far as the market is concerned, anything less than walking on water is a bit of an anti-climax.
The thing is, for all its talk, the Fed didn’t actually do anything extra. And that leaves markets in a bit of a limbo situation.
The rebound since the March lows has been driven by two things. One factor is that once an economy has tumbled off a cliff, things can only get better. Once the news stops getting worse, markets tend to turn around. That’s your “relief rally”, where markets go up because although the news is bad, it’s less bad than expected.
But that only lasts for so long. Eventually, markets get ahead of themselves again, and you start getting disappointed reactions even when the economic data is much better than expected.
The Fed wants politicians to act – but will they?
The second factor – and arguably the more important one – is, of course, the Fed. The US central bank reacted very quickly during this crisis to underwrite not only the US financial system, but also the global financial system.
That prevented us from getting that existential panic we saw in 2008, where no one would willingly put a price on anything, because no one was entirely sure that anyone would still be in business the next day.
But having underwritten the system, it’s not clear what the Fed can now do by itself to accelerate any recovery. This tells us something about where we are in terms of the politics of monetary policy.
I listened to an excellent Bloomberg “Odd Lots” podcast the other day with Paul McCulley, formerly chief economist at bond fund giant Pimco. He argues that, in effect, we’re now seeing a shift from a technocratic “monetary policy dominant world” back to a democracy.
In other words, control of money is moving from capital (the relative minority of people who own assets and already have money) to labour (the majority of people who earn their money from wage income rather than assets).
You can certainly take issue with McCulley’s framing of the topic. But the picture he sketches – where monetary policy is basically at the end of the road, and politicians now are taking charge, one way or the other – I feel, is accurate.
So really what the Fed is now doing is similar to what the European Central Bank spent a lot of time saying a few years ago under Mario Draghi.
That is: “Politicians, it’s up to you. We’ll keep interest rates low. We’ve got your back. You now need to spend money to get the economy going and employment rising.”
Eventually, you have to expect that someone will take the central banks of the world up on that offer in a wholehearted manner, as opposed to the somewhat more timid approach we currently have.
So that’s the overall narrative. It’s not so much that central banks are out of ammo. But they’re at the stage where they really need to hand the gun over to the elected politicians. It’s one thing to simply print money. It’s quite another to decide who gets it. Voters need a say in that.
The question now is: when does the shift actually happen?
The obvious move would come if US politicians can agree to a deal to extend coronavirus stimulus packages further. I suspect any deal would send markets a lot higher. However, given that we’re getting ever closer to what promises to be a very bad-tempered election, there’s clearly a good chance that this won’t happen.
I would expect the next president – whoever gets in – to try to splurge a bit. But you have a long period of no man’s land between now and then. And that period might well be extended by any disputes over the result.
So it’s an interesting environment for financial markets, particularly given that most assets seem to be priced quite highly. Will we get a correction before or during the election? Or will everything keep heading higher?
Something to watch is that right now, stock markets are teetering on various important technical indicators (Dominic has written about them a few times recently). Whatever you think of charting, these are lines and levels that lots of people in markets do pay a lot of attention to.
If markets slide below them, that might be enough for a lot of people to take profits and sit on their money until the election uncertainty has passed, or until the Fed comes out with some other sort of massive bribe to force people back into the market.
Again, this is mostly for interest. Unless you’re a short-term trader (I don’t recommend it), then none of this should affect your long-term plan. But it’s nice to know what might lie ahead, so that you a) don’t panic; and b) make sure you’re prepared to take advantage of any opportunities that arise if everyone around you starts to panic.
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