Just listen: what the Fed is saying
If yield curves are to be believed, market consensus would appear to be that an acceleration in economic activity is likely to spark inflation. However, a read through the thoughts of Fed Chief Powell seems to point to the opposite. Furthermore, the Fed's own concerns about their inability to insulate the economy through monetary policy are clearly at the forefront of their collective minds.
It is rare that the US Federal Reserve changes its policy framework under which they strive to meet its two government-mandated goals of stable prices and maximum sustainable employment. In September it did just that releasing its “Revised Statement on Longer-Run Goals and Monetary Policy Strategy.” After a brief history lesson, Fed Chairman Powell noted that by the 2000’s inflation targeting became the norm with an enormous emphasis on communication and transparency; they wanted markets to know what they were thinking. To many (including ourselves), this was also the point where policy started to be more pointed toward placating markets than regulating the underlying economy. As previously pointed out, the tail began to wag the dog.
More importantly for investors, the change in policy formation and examination of its process gave insights into its concerns, leanings and forecasts. While markets have tended toward knee-jerk reactions to snippets of Fed statements, a closer look is useful in understanding where it thinks economies are heading and the settings to which it will adhere. These, in turn, will drive markets. As can be seen, it appears the fed is less sanguine on growth and inflation than Wall Street.
Powell went on to discuss four key economic developments which sparked and drove the review. While receiving little airplay, they give great insight into the Fed’s thinking which is critical when considering the economic outlook:
- Firstly, “..assessments of potential, or longer run, growth rate of the economy have declined.” He went on to point out that the projections for long term output growth has steadily dropped. As we have noted, over a longer period this has coincided with sharply rising government debt / GDP ratios.
Time Projections of Longer-Run Real Gross Domestic Product
- Secondly, “… the general level of interest rates has fallen both here in the United States and around the world. Estimates of the neutral federal funds rate, which is the rate consistent with the economy operating at full strength and with stable inflation, have fallen substantially, in large part reflecting a fall in the equilibrium real interest rate…” Note that this rate is not affected by Fed monetary policy, but by underlying economic fundamentals. Powell noted that since 2012 the neutral rate had fallen from 4.25% to 2.5%.
Real Time Projections of Longer-Run Fed Funds Rate
- Thirdly, on a positive note Powell pointed out the strength of the labour market leading into the pandemic. This included the participation rate (percentage of people actively in or seeking employment) having risen back to pre-GFC levels. This was contrary to expectations that the GFC had caused structural damage to labour markets. Powell then went on to expand his comments emphasizing that gains were shared widely across the community with Black and Hispanic unemployment rates reaching record lows.
- We have written several times that one of the biggest surprises since the GFC was that the liquidity explosion and unprecedented stimulus did not result in inflation despite apparently tight labour markets. Powell’s fourth point concurs as he notes that all forecasters estimated that inflation would be moving back to 2%, but that this did not occur. He also noted that inflation estimates are based on what is considered the “natural” rate of unemployment. As the actual unemployment rate moved lower without inflation, so too did the FOMC estimate of the “natural” rate of unemployment because, well, that’s how the math works!
Evolution of Real-Time Projections for Personal Consumer Inflation
Real Time Projections of Longer-Run Unemployment Rate
Other major points from both the speech and the subsequent release of the latest Fed meeting minutes a few weeks later are as follows:
- Powell notes that consistently coming in under the 2% target would impact inflationary expectations to continue to decline taking interest rates with them. In Powell’s own words, “if inflation expectations fall below our 2 percent objective, interest rates would decline in tandem. In turn, we would have less scope to cut interest rates to boost employment during an economic downturn, further diminishing our capacity to stabilize the economy through cutting interest rates. We have seen this adverse dynamic play out in other major economies around the world (NB: Japan) and have learned that once it sets in, it can be very difficult to overcome. We want to do what we can to prevent such a dynamic from happening here.”
- He stated that they viewed having an explicit goal for the unemployment rate as unwise. This is understandable given the huge move in the “natural” rate over the last decade. This is despite one of the Fed’s two mandates being……sustainable full employment!
- The statement has substituted “shortfalls” in place of “deviations” when discussing maximum employment. Powell singles this out in his speech noting that this means employment can run above it’s maximum estimates, as can inflation.
- The over-arching tone in the speech was setting policy while expressly considering “all Americans,” giving the sense that policy settings will deliberately place higher weight on impacts to lower socioeconomic groups.
- The Fed minutes revealed a consensus forecast of FOMC members of the Fed Funds rate anchored at the current 0.25% until at least 2023. In the subsequent press conference Powell once again stated that more fiscal stimulus was needed.
Powell went on to say, “This decline in assessments of the neutral federal funds rate has profound implications for monetary policy. With interest rates generally running closer to their effective lower bound even in good times, the Fed has less scope to support the economy during an economic downturn by simply cutting the federal funds rate. The result can be worse economic outcomes in terms of both employment and price stability, with the costs of such outcomes likely falling hardest on those least able to bear them.”
There you have it. The Chairman of the Federal Reserve holds the same concerns that many market practitioners have held for years: central banks may be running out of bullets, at least the traditional kind. Of course, he has only explicitly stated this after 1) utilising non-conventional monetary policy (quantitative easing, direct intervention in debt markets) for the last decade, and 2) continually voicing the need for fiscal stimulus to pick up the slack. Finally, it’s always a concern when it is felt there is the need to address the concern directly. During his press conference post the release of the latest Fed meeting minutes Powell stated, “I certainly would not say we are out of ammo…”
Thus, the key takeaways for us are as follows:
- Our central assumption of inflation lower for longer appears in line with Fed thinking with the current tail risk regarding pricing being deflation, not inflation.
- The Fed appears to be less sanguine on growth than those on Wall Street and they point this out in both their charts and their commentary.
- They have been as surprised by the lack of inflation as labour markets tightened as we are. However, that there is no mention of possible causes for a change in what was a fundamental tenet of economics is of some concern. We don’t have the answer, we were hoping they did!
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David is the principal of ICN, an investment consultancy providing investment and asset allocation advice to Australian businesses and investment companies. Prior to ICN, David was an institutional portfolio manager, both long only and absolute...