When the Fed raises or lowers interest rates, they don’t really know the full economic impact for at least a year. Such a long lag makes the job of setting monetary policy very difficult.
The experience of the runaway inflation in the 1960s and 1970s left an indelible mark on how the Fed conducts monetary policy. Namely they adopted a proactive approach. It’s not about where inflation is today; it’s about where inflation is likely to be a year from now. As such, the Fed would somewhat blindly raise rates with the expectation of tamping down a fire that is expected to start a year away. This approach exposed the Fed to both timing and magnitude risks. Lately, we are seeing signs that the Fed is beginning to reconsider this approach which could have a meaningful impact for our economy and the markets in the future.
Unemployment & Inflation: Fit to be Untied?
While the Fed considers many factors in their decision making, the unemployment rate has been one of the most prominent. Historically, there has been an inverse relationship between the unemployment rate and subsequent inflation (an economic concept developed by A.W. Phillips and referred to as the Phillips curve). Typically, a very low rate of unemployment has been seen as a trigger for inflationary pressures. Yet during this economic cycle that relationship hasn’t held; the unemployment rate continues to fall but inflation remains range bound. In July 2019 testimony to the Senate Banking Committee, Fed Chairman Jerome Powell stated that the tie between unemployment and inflation “has become weaker, and weaker, and weaker.”
Source: Bloomberg
Inflation: The Problem or the Solution?
We need to embrace the mindset that inflation a bit above target is far better than inflation a bit below target in today’s economic environment.This is very different language coming out of the Fed.
Daly went on to state that despite low unemployment, wage gains have remained modest, “few models would have predicted this. Little history would have told us this was possible.” She added that “our traditional approach” to monetary policy is no longer effective in today’s market environment.
So, exactly how do you conduct policy if your models don’t work and history is no longer a guide?
This has been the topic of a yearlong series of “Fed Listens” events to get input from academics, policy makers, business leaders and others on different approaches to achieving their policy objectives and how to communicate them. While my eyes want to roll at the idea of a Fed listening tour, it appears that it may be more influential than originally expected.
Reframing the Target
You may think, who cares, they can’t even reach their 2% target. As investors, I think we should care. A lot. While the Fed may not have singularly caused every recession going back to the 1950s, they certainly had a hand in every one of them. If the Fed becomes less anticipatory in their policy decisions, they are much less likely to make a preemptive mistake and put us in a recession. In 2019, the Fed partially re-opened the liquidity damn and then told us it is likely to remain open for the foreseeable future. While many question whether this will result in higher inflation, it certainly appears to be resulting in higher asset prices.
Can’t Stop Thinking About Tomorrow
At the start of this year, we did recommend dipping a toe into more cyclical exposure and reducing bond duration. We noted that Central banks around the world have been very accommodative and with the signing of the phase one trade deal we expected a global upturn. There had been confirming signs of an upturn, but the outbreak of Coronavirus has arrested the rise. We do think investors should look through this viral event as we believe it will prove transitory, though admittedly the near-term economic damage looks to be larger than originally thought.
This summer, the Fed will more formally address the listening tour and how it may impact monetary policy going forward. Meanwhile, the risk of the Fed raising rates has meaningfully receded into the distance.
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