Through a glass, darkly
- I had a twenty-five-year career in the official sector, at the Bank of England and the International Monetary Fund
- The most common question I am asked by clients today is: can the Fed engineer a soft-landing in the US and, by extension, the global economy?
- Based on my experience the answer is: yes, but expect a turbulent flight
- What does this mean for investors? If they can preserve optionality and have strong enough nerves, there will be opportunities to add risk to portfolios at more attractive entry points
Interpreting the Fed
Unless you’re standing directly in front of someone, they’re almost certainly not thinking about you; and, even if you are standing directly in front of someone, they’re far more likely to be thinking about themselves than about you. So it is with central banks and financial markets: each views the other through the lens of its own issues.
For many years, it was part of my job at the Bank of England, working closely with colleagues in other major central banks, particularly the New York Fed, to explain and interpret market developments to senior policymakers, including the Monetary Policy Committee. They weren’t always an easy audience. A common objection was that studying financial markets for insights relevant for policy was like being a monkey transfixed by its own reflection in a mirror.
Since the global financial crisis, there’s acceptance among senior central bankers of the need for analysis of and dialogue with markets. That’s because central banks now routinely operate in more than just the core money and foreign exchange markets: via quantitative easing and their liquidity-supplying operations they buy outright or lend against mortgage and asset-backed securities as well as corporate debt, for example.
Gone are the days when policy decisions were a simple matter of up or down 25 basis points, or sit tight and re-assess next month. Now, they need to know what’s going on, and to explain themselves.
Even so, misunderstandings arise. After an initial honeymoon period, Bank of England Governor Mark Carney experienced something of a lovers’ tiff with markets, who called him an “unreliable boyfriend”- unfairly, I think. To markets, he appeared to be changing his interest rate guidance from month to month. Within the Bank, our view was that he was explaining a policy that was state-contingent rather than time-contingent, to a broader audience than financial markets professionals – and that the woman and man in the street understood perfectly what he was saying. However, no matter how many times I and others said and wrote that “guidance on the likely pace and extent of interest rate rises was an expectation, not a promise” – the epithet stuck.
Meanwhile, the so-called Taper Tantrum of 2013 was a more consequential misunderstanding, more like throwing pots and pans than a lovers’ tiff. But it had a similar root: the challenge the Fed had to explain, and that the market had to process, the nuances of a policy reaction function that was state-contingent; and conditioned on an economic forecast whose distribution of outcomes embodied a high degree of uncertainty.
All of which is to say that understanding central bank messaging today is as crucial as ever for investors. So what is my take on what the Fed is trying to do, and can it achieve its goal?
Is a soft-landing possible?
The question that comes up most often in my conversations with our institutional partners is, essentially: Can the Fed engineer a ‘soft-landing’ in the US and, by extension, the global economy? For what my own view is worth, the answer I give is: Yes, but the flight will be turbulent and the landing strip is narrow.
In investors’ minds, a successful ‘landing’ involves the Fed scaling back and then ending asset purchases, and eventually raising interest rates, with such skillful choreography that it meets its inflation and employment objectives while avoiding a crash in real and financial asset valuations.
The well-trailed taper, pause and interest rate lift-off in December 2015 show that it can be done. Today’s situation is more complex, however. The Fed has a new monetary framework, fiscal policy represents a tailwind of uncertain strength, and the Covid-19 public health crisis and recession have multiplied uncertainties about key economic variables and relationships beyond even those described by Chairman Powell in his ‘navigating by the stars’ Jackson Hole speech in 2018.
There are at least three challenges for the relationship between the Fed and the markets. First, that of understanding the new framework and guidance in the context of uncertainty. Second, there’s an appreciation of the scale of the challenge of communication and execution facing the Fed, and some scepticism as to whether it will succeed in pulling it off. Third, many people anticipate stronger underlying inflationary pressure than the Fed currently does, which contributes to an element of mistrust of the Fed’s motives and whether it will take risks that investors should be concerned about.
It’s worth taking each of those challenges in turn.
The Fed’s new framework
I believe the Fed’s new Average Inflation-Targeting (AIT) framework represents an elegant and uncluttered response to the times we are in. As trailed in Ben Bernanke’s blog, set out formally in research papers he has co-authored, and as Vice-Chairman Richard Clarida has explained in speeches on a number of occasions, it has two aspects: a period of Temporary Price Level Targeting (TPLT), followed by a return to flexible and symmetric inflation targeting within a Taylor Rule framework.
Two things underlie the TPLT approach. A view of the inflation formation process that emphasises the primary importance of anchoring expectations at the two per cent target. Next, the problem that low inflation expectations cause when nominal rates are stuck at the Effective Lower Bound – arithmetically, it constrains the Fed from cutting real interest rates further. That’s the reason for the period of TPLT. It affirms that bygones are not always bygones, and that a period of partial price-level catch-up is required after years of inflation undershoots to raise inflation expectations back up to two per cent. The beauty is its relative simplicity and flexibility: it avoids complex, and probably inoperable, rules about look-back and catch-up periods that would be required if price level targeting was a permanent regime.
AIT has been introduced after years of central bank head-scratching about weak inflation but at a time when there is now plausibly more of an inflationary threat than there’s been for thirty years. There’s little I can usefully add to the volume of commentary already produced on that, except to say that I think all major central banks remain more impressed by secular disinflationary forces than by cyclical inflationary pressures. And that central banks mean it when they say they are as uncertain about many features of the near-term outlook as the rest of us. That includes short-term supply bottlenecks as lockdowns ease, pent-up demand for healthcare, the multiplier on fiscal stimulus, the propensity to spend Covid-induced savings, the potential for a sudden increase in animal spirits, and when they might encounter a kink in the seemingly-flat Phillips Curve.
Fed’s focus will be on measures of the underlying inflation generation process: in the labour market, particularly the extent to which wage rises are paid for by productivity increases or can be absorbed in companies’ margins.
Where that leaves things is with the Fed wanting: to avoid past errors and wait until it sees evidence of actual inflation, rather than merely forecast inflation, as a guide to action; and looking at a wider array of indicators of labour market slack and inflation expectations as it weighs the relative risks of unemployment and inflation. The Fed will (obviously) look through base effects pushing inflation up in the near-term, and through one-off changes to the price level caused by short-term supply constraints as the economy normalises. The focus will be on measures of the underlying inflation generation process: in the labour market, particularly the extent to which wage rises are paid for by productivity increases or can be absorbed in companies’ margins.
A communication challenge
What ultimately matters for any central bank is getting its message across to ordinary citizens. Wall Street is part of the transmission mechanism, but the success of policy depends on its effect on the spending behaviour of businesses and households. In that sense, there are parallels now with Mark Carney’s ‘unreliable boyfriend’ phase. There’s a lot of complexity and uncertainty for markets to process, but the Fed’s message to Main Street is relatively straightforward: ‘Output and inflation are going to be volatile for a bit, but we’ve got your back; we’re not going to kill the recovery; don’t worry about inflation’.
It’s usually better to be vaguely right than precisely wrong. But, understandably, the reassuring simplicity of the message isn’t enough for Wall Street. Markets have a hard time pricing uncertainty and aren’t greatly reassured by the knowledge that in many important respects policymakers are as uncertain as they are. The Fed communicates extensively and repeatedly about its new framework, including the “five features” that define how it will seek to meet its price stability mandate, and about its outcome-based forward guidance, including the assessments of individual FOMC members in the Summary of Economic Projections (SEP).
But, inevitably, markets will always push the Fed for more information than it can give. One example among many is about the timetable for tapering QE asset purchases. That’s a question without an answer, because the Fed doesn’t know either – it’s contingent on an outlook for the economy which is highly uncertain, and on a set of decisions by a committee that hasn’t discussed it yet.
The third big challenge to the relationship between the Fed and the market is scepticism. If I set to one side the views of noisy professional commentators vying for attention in a cut-throat marketplace, there’s still a degree of scepticism that extends to quiet people whose jobs are to invest for the long-term on behalf of asset owners. A range of views and some disagreement about the outlook for the recovery and the prospects for inflation is understandable. However, there is also some concern that inflation expectations might become de-anchored to the upside as a result of a combination of fiscal stimulus and the Fed’s commitment to allow a temporary inflation overshoot.
That’s potentially more worrisome for the Fed, however much it and many academic commentators might disagree with that analysis of the inflation expectations generation process. One important point they would make is that it took a decade of wars, sub-optimal macro policy, the breakdown of the Bretton Woods System, structural unrest in labour markets and a major oil price shock to raise inflation and inflation expectations fifty years ago. That’s plainly not the situation now. I particularly like Joe Gagnon’s neat summary note on the fiscal policy aspects of this debate in which he argues that the Korean War is a better analogy to the present situation than Vietnam.
More worrisome is the sense that some market players are going beyond doubting whether the Fed will make the right calls on the economy and policy, and questioning its motivations on inflation and the labour market. To some extent that’s familiar territory for any central bank. For example, Sterling fell by about a quarter during the financial crisis. When that passed through to inflation, which hit five per cent during a recession when the Bank of England had undertaken a very large quantitative easing programme, there were accusations that the Bank was ‘trying to inflate the debt away’.
I remember at the time that we really struggled to counter that. Even sarcasm, such as pointing out that ‘if we were that clever we wouldn’t be in this mess in the first place’, didn’t really cut through. But questioning of the Fed goes beyond that and examines the language it uses about the relative risks of inflation and unemployment for hints of political capture, or even of taking sides in the culture war. That’s a sign of the times, and well beyond the control of a central bank, but it’s not a great place to be in.
There’s every reason for central banks to be concerned that markets won’t be efficient and that excessive volatility could compromise the effectiveness of policy.
What does this mean for investors?
Hopefully you now appreciate how central banks and markets look at each other through the lens of their own issues, and that misunderstandings are possible and indeed likely in the current environment. I’ve tried to shine a light on central banks, and the Fed particularly, to offer a perspective that might help explain where they are coming from. But what about the perspective of the central banks on markets? And does any of this really matter for investors?
Ultimately what matters for central bank policy is the real economy. Financial markets are part of the transmission mechanism between the central bank and Main Street. As long as markets are essentially efficient at smoothly incorporating information into pricing over time, central bank policy-makers needn’t care too much about markets.
They haven’t really had that luxury since the financial crisis. Given innovations in the Fed’s and other central banks’ policy frameworks, and pervasive uncertainty about the Covid-19 pandemic and recovery from the recession, there’s every reason for central banks to be concerned that markets won’t be efficient and that excessive volatility could compromise the effectiveness of policy.
It’s been a few years since I sat in a central bank policy meeting, or round one of the large oval meeting tables at the BIS in Basel with other central banks discussing these topics. But I have no doubt they will now be sat around their virtual tables, warily eyeing markets in much the same way exhausted parents look at small children, not knowing whether they are about to demand a hug or throw their toys out of the play-pen.
There are any number of ways this could all play out, but I’ll suggest three main scenarios.
First, everything could go perfectly well. The economy recovers from the recession, employment rises to at least pre-pandemic levels, a modest short-term inflation over-shoot raises and anchors expectations to the two per cent target, the yield curve rises progressively to reflect inflation expectations at target and real rates in line with Fed’s SEP (let’s say the six-month nominal rate five years’ forward is around 2.5 per cent, based on current SEP projections). The Fed would then be in the fortunate position of being able to lift-off and raise rates in a way that it is basically validating the path that the market had already moved to discount. That would be central banking heaven – and an easy ride for investors.
Alternatively, things could go badly. The Fed could be wrong about the strength and persistence of inflationary pressure, and mistaken in thinking a modest rise in rates would be all that was needed to get it back under control. That is certainly possible, although to me it seems improbable. It would be hell for central banks and most everyone else.
A more likely adverse scenario is that the market moves to price in more inflation than the Fed is expecting, and more inflation than is warranted by the strength of the economy, and persists in that view for long enough that it forces the Fed’s hand to raise rates pre-emptively. Given the truculent and slightly distrustful mood in parts of the market, it might take only a short series of erratically strong data releases to bring that about.
I have a problem with this scenario, however: it seems likely that both the inflation compensation and real components of the yield curve would rise, potentially sharply, and risky asset prices would probably fall heavily. In those circumstances, I suspect the effects of the rise in the cost of capital and negative wealth effects on consumption would bring the yield curve back into line well before the Fed felt it had to tighten policy. But smarter people than me do put weight on this scenario, and I include it for that reason. It would be unpleasant but not the end of the world. Assuming the Fed was right ex post about the underlying inflation process, a relatively short series of modest interest rate rises would probably be all that was needed to bring the market to its senses.
Most likely, if the near future is anything like the recent past, it is something between those two extremes. That relies on the Fed being basically right and markets over time moving to price that, but with episodes of volatility that are ultimately just noise rather than precursors of a persistent adverse shift in the economy.
Quantitative easing by the major central banks dampens volatility and creates a difficult environment for markets to take the short side against the Fed. As all fixed income portfolio managers know, it’s a negative carry position and painful to be in for any length of time while you wait for it to work out. On the other hand, given the sceptical tone in the market, and the vague sense that being short rates could be the next generational trade, the bar is probably set low in terms of a run of strong data triggering a further wave of rising market rates.
If that coincides with one of the local peaks in leverage in the equity market – something like the recent Archegos episode – there could be a messy few weeks. That’s likely to trigger speeches from central bankers about having lots left in the tool-kit, and perhaps even further increases in asset purchases. But if investors have strong enough nerves to look through the noise, there would be opportunities to add risk to portfolios at more attractive entry points.
Market valuations don’t appear out of alignment when conditioned on the level of the risk-free yield curve.
Deconstructing Fed policy and forming a view on US rates is just one of the macro strategy challenges facing investors, but it is probably the most important. We’ve learned a lot in the last decade about the strength of the financial channel between US yields and markets across the globe – both as the key determinant in pricing, and of investor flows to and from non-US markets.
I well remember from about 2010 onwards regularly being asked by the Bank of England Monetary Policy Committee whether financial markets were over-valued. It’s a major talking point with clients now, of course. The answer I gave then, and the answer my investment strategist colleagues at HSBC Asset Management give now, is that market valuations don’t appear out of alignment when conditioned on the level of the risk-free yield curve.
However, to say that is simply to focus attention back onto the expectations management challenge facing the Fed in the long process of policy and yield curve normalisation.
It’s hazardous to generalise. But while most of the large investors I talk to like to argue about all of this, and are anticipating a turbulent flight, no one is seriously tempted to bail out right now. They might be cautious in adding overall risk to the portfolio at this point, but they do not want to be underweight the recovery. Where they are able to, many are preserving liquidity and optionality, expecting to exploit opportunities to buy into dips where they see value during episodes of volatility. Neither I nor my colleagues would challenge the wisdom of that approach.
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