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.
Subscribe to MoneyWeek
Subscribe to MoneyWeek today and get your first six magazine issues absolutely FREE
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.
John is the executive editor of MoneyWeek and writes our daily investment email, Money Morning. John graduated from Strathclyde University with a degree in psychology in 1996 and has always been fascinated by the gap between the way the market works in theory and the way it works in practice, and by how our deep-rooted instincts work against our best interests as investors.
He started out in journalism by writing articles about the specific business challenges facing family firms. In 2003, he took a job on the finance desk of Teletext, where he spent two years covering the markets and breaking financial news. John joined MoneyWeek in 2005.
His work has been published in Families in Business, Shares magazine, Spear's Magazine, The Sunday Times, and The Spectator among others. He has also appeared as an expert commentator on BBC Radio 4's Today programme, BBC Radio Scotland, Newsnight, Daily Politics and Bloomberg. His first book, on contrarian investing, The Sceptical Investor, was released in March 2019. You can follow John on Twitter at @john_stepek.
Who is the richest person in the world?
The top five richest people in the world have a combined net worth of $825 billion. Who takes the crown for the richest person in the world?
By Vaishali Varu Published
Top 10 stocks with highest growth over past decade - from Nvidia, Microsoft to Netflix, which companies made you the most money?
We reveal the 10 global companies with the biggest returns since 2013. One firm has posted an astonishing 9,870% return, meaning a £1,000 investment would now be worth almost £82,000.
By Ruth Emery Published
UK wages grow at a record pace
The latest UK wages data will add pressure on the BoE to push interest rates even higher.
By Nicole García Mérida Published
Trapped in a time of zombie government
It’s not just companies that are eking out an existence, says Max King. The state is in the twilight zone too.
By Max King Published
America is in deep denial over debt
The downgrade in America’s credit rating was much criticised by the US government, says Alex Rankine. But was it a long time coming?
By Alex Rankine Published
UK economy avoids stagnation with surprise growth
Gross domestic product increased by 0.2% in the second quarter and by 0.5% in June
By Pedro Gonçalves Published
Bank of England raises interest rates to 5.25%
The Bank has hiked rates from 5% to 5.25%, marking the 14th increase in a row. We explain what it means for savers and homeowners - and whether more rate rises are on the horizon
By Ruth Emery Published
UK wage growth hits a record high
Stubborn inflation fuels wage growth, hitting a 20-year record high. But unemployment jumps
By Vaishali Varu Published
UK inflation remains at 8.7% ‒ what it means for your money
Inflation was unmoved at 8.7% in the 12 months to May. What does this ‘sticky’ rate of inflation mean for your money?
By John Fitzsimons Published
VICE bankruptcy: how did it happen?
Was the VICE bankruptcy inevitable? We look into how the once multibillion-dollar came crashing down.
By Jane Lewis Published