Don't fight the Fed – at least, not yet

The US central bank has made it clear it will keep propping markets – at least until inflation takes off. Betting against it would be a bad idea. But, says John Stepek, don’t make the mistake of thinking the Fed is an all-powerful master of the markets.

There were no fireworks at the latest Federal Reserve monetary policy meeting.

But in case you were in any doubt, Fed chief Jerome Powell made it very clear last night that higher interest rates are not even close to thinking about dreaming of drifting onto the horizon of the US central bank’s long-distance radar.

No rate rises. Ongoing cheap money.

They say: “Don’t fight the Fed” – and who are we to disagree?

Inflation is the one thing that can derail central bank support for markets

“We’re not even thinking about raising rates,” said Federal Reserve chief Jerome Powell last night. He justified this by arguing that the coronavirus is “a disinflationary shock… we see core inflation dropping to 1%. I do think for quite some time, we’re going to be struggling against disinflationary pressures."

Now we can debate the latter point, but the big takeaway here for investors is that the Fed is not going to be getting worried about inflation, and certainly not about rising asset prices, any time soon.

The old market saying is: “Don’t fight the Fed”. How true is it? Much as I hate to say it, the saying has held a lot of water in the last few decades.

Central banks can't prevent a big bear market from happening, as we’ve seen in the past. But what has happened is that they’ve grown increasingly willing to step in to underpin the financial system as soon as there’s any sign of stress.

That in turn has meant that rallies following collapses in the market have become ever more rapid. The most recent coronavirus one was the quickest on record. On the one hand, you can argue that the coronavirus shock is unique, and it is. But on the other hand, so was the enormity of the Fed’s response.

The closest we've come to a more traditional bear market (in the US, at least) in the last ten years was when the Fed decided that it would start raising interest rates when Powell first took the role in 2018. That was brought to an end pretty sharpish, primarily because markets threw a hissy fit.

In short, it took Powell a while to realise that his job is mostly about propping up the S&P 500 – and thus for markets to trust him – but he got the message eventually.

So if the Fed is on board with keeping monetary policy loose, then history suggests that betting on collapsing markets is a losing game. The truth is that central banks have proved that they can prop up asset prices, even in the face of disinflation or deflation.

The usual “but what about Japan?” question doesn’t even apply here. The Japanese central bank may have been unable to spark consumer price inflation, but since it took the gloves off under Shinzo Abe, the Japanese stockmarket has done perfectly respectably.

As I’ve said many times before, the only thing that can really put a spoke in the wheels of this market is a proper rip higher in inflation. That would be a problem, because central banks can’t tackle inflation with loose monetary policy. Once inflation gets going, you either let it go higher, or you tighten up.

However, central banks want inflation to rise. You can safely assume that the global inflation target of central banks is no longer 2%. They’d like inflation to be higher. They need inflation to be higher.

So they will let it go up. In turn, that means you don’t have to worry about central banks tightening up until inflation is already a problem. At that point, it’ll probably be apparent in wider markets in any case.

Don’t mistake an infinite supply of funds for economic mastery

Can central banks get inflation to go up? That’s the wrong question.

I agree that “don’t fight the Fed” is good investment advice. However, don’t mistake that for omnipotence. The economy is not a machine, and the Fed is not a genius engineer, tinkering with said machine.

“Don’t fight the Fed” is good advice simply because a determined, price-insensitive buyer with an infinite sum of money is always going to trump the fundamentals, regardless of how bad you might think they are. A refusal to accept that is just stubbornness.

As far as inflation goes, I’ve already discussed a lot of reasons why I think it could and should go up. And a lot of smart people who have been deflationists during the last decade (correctly) are now changing their tunes. That seems worth watching.

However, as far as your investments go, you don’t really need to worry about exactly when inflation will take off. As of right now, it’s not here. So be prepared for it (own some gold – which will no doubt have a wobble as it’s been overbought, but don’t stress about that).

But also be aware that it’s fine to keep holding equities and sticking to your long-term plan. It seems unlikely that a fresh crash is around the corner.

Central banks are making it clear that they’ll step in where market stress looks like it’s getting out of hand. Governments are clearly a bit nervy about the amount of money they’re spending, but we’re also in a new era where austerity is very much a dirty word. So when push comes to shove, the purse will come out.

And there are plenty of appealing prospects out there, whether you like sectors and themes, or individual stocks. We not only look at gold and silver (of course) in the next issue of MoneyWeek (out tomorrow) – but we also look at fintech and commercial property funds, just to pick a few of our features. If you’re not already a subscriber, sign up now and get your first six issues free.


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