How long can the Federal Reserve keep markets happy?

Last night’s meeting of the US Federal Reserve was – for markets at least – probably the most important it's had since the peak of the Covid-19 crisis.

As we've been writing about for a while, markets are a bit nervous. Investors are happy that the global economy is recovering and bouncing back, and that's all good news for corporate profits (overall, at least). But recovery also means something else.

Firstly, it means the economy is stronger and so it doesn't need as much support from central banks. Secondly, there's also the risk that prices rise quickly because of lots of demand hitting bottlenecked supply. If inflation takes off – which investors increasingly expect – then that also implies tighter monetary policy.

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The Fed is promising markets that it won't lift interest rates for a long, long time

Markets have grown used to a very supportive central bank. But, if the Fed starts to tug that support away, can they cope? A similar question arose in 2013, and we got the “taper tantrum” which then forced everyone involved to start rowing back hard.

It's clear that the Fed has learned its lesson from that and countless other little tantrums in the past. Fed chief Jerome Powell yesterday made it very clear that a) he's supremely relaxed about inflation, and b) it's good to see the economy recovering, but there's a long way to go.

The Fed did increase its expectations for US growth this year; it also expects unemployment to go down faster than thought previously. So the central bank reckons 2021 will be a good year for the US. However, it also made no real change to its own interest-rate expectations. It still doesn't expect interest rates to be above zero before 2024.

In short, the message is: the economy is going to recover, and that's good news, but we don't see any pressing need to raise interest rates for a good long while.

That's what the market wanted to hear. And in his press conference, Powell pushed the message more aggressively. He said, yes, inflation is likely to be higher in the next 12 months, but emphasised that it's all “transitory”. In other words, the Fed won't pay it any heed. He also focused closely on unemployment being too high, and made it clear that getting this down is the Fed's priority.

As John Authers puts it in his Bloomberg letter: “Powell was telling everyone that the Fed now cares more about unemployment than inflation, and that there's no need to worry that the likely inflation scare over the next few months, as the great shutdown passes more than 12 months into the past, will shake the [Fed] into tightening monetary policy.”

The immediate result was not surprising. The US dollar weakened (if interest rates are going to be stuck to the floor for longer, it usually means a weaker currency); stockmarkets shot up (they like a weaker dollar); bitcoin surged. Even gold, which has been mired in its own slough of “risk-on” despond recently, managed to perk up above $1,740 an ounce. And yields on long-term bonds continued to rise, steepening the yield curve.

What if the Fed is underestimating inflation?

Put simply, the Fed is saying that the economy is heading for a healthy reflation. So you get growth coming back and long-term interest rates rising a bit, but you don't get the sort of lasting surge in inflation that undermines all that growth. So the Fed can afford to stand back for a while longer and not worry about tightening monetary policy.

This is the “Goldilocks” scenario, and for now investors are reassured that the Fed still believes in it, and plans to act as though it's the case. It also suggests that the various “reflation” trades – particularly bank stocks – should keep doing well.

It's important to keep an eye out though. The biggest question is: how much inflation can the Fed ignore? And at what point might it have to do something more aggressive than talk about ignoring inflation?

As Michael Pearce of Capital Economics points out, this is the main risk to the Fed's forecasts. “Surveys suggest rising price pressure are broad-based, wage growth is elevated given the spare capacity in the labour market, and inflation expectations have trended higher over the past year”.

If inflation doesn't drop back or surges more powerfully than expected, then the Fed will have to come back and convince the market all over again that it's not going to act. That's when things start to get more interesting, and not necessarily in a comfortable way.

Anyway, we'll be writing a lot more about that in the coming issues of MoneyWeek magazine. You can get your first six issues plus a beginner's guide to bitcoin absolutely free here.