Fed Tightening Without Inflation: Insights for Investments, Forex, and Stocks
The Fed has been signalling a continuing of monetary tightening, while markets were skeptical about future rate hikes in the face of low inflation. This is a recurring theme in industrialized economies, as the global tightening cycle has modestly begun, while unemployment rates reach low levels and economies start approaching “full capacity” outside the Eurozone.
Notice the absence of inflation all around the world. The UK has a bit of inflation due to the huge depreciation of the Pound in 2016–2017 causing import-push inflation (imports cost more due to the weaker currency, which adds price pressure on goods and services in the economy).
Long term interest rates, stocks, and central bank policy
Like the rest of the industrialized world, the Fed does not fully understand why inflation remains so low:
“The influence of labor utilization on inflation has become quite modest over the past 20 years, implying that the inflationary consequences of misjudging the sustainable rate of unemployment are low. But we cannot be sure that this modest sensitivity will persist in the face of strong labor market conditions, given that we do not fully understand how it came to be so modest in the first place.”
Janet Yellen, Tuesday Sept 26, 2017
The Fed says it will gradually shrink its balance sheet (which removes money from markets) and continue on course with slow and gradual monetary tightening.
This suggests the Fed thinks that inflation will pick up in 2018–2019 due to the tight labor market and a good outlook, thus supporting business investment and consumer spending, with the added bonus of Trump’s fiscal stimulus (will it really happen?).
To avoid a fast-and-nasty policy tightening in 2018 in the face of potentially fast-rising inflation, the Fed decided to go with a slow and gradual approach to avoid an interest rate shock in 2018–2019 to avoid recession risk. The same “change of tone” has been seen in Canada, suggesting the Bank of Canada sees 2018–2019 inflation, even in the face inflation currently sitting well below target and showing little signs of a pickup.
All this “tightening talk” does one thing: inflation expectations are kept low, and this keeps a lid on long term interest rates (just trust me on this). This means long term rates remain lower than they otherwise would be and the yield curve remains quite flat, suggesting the market as a whole remains skeptical about the possibility of even modest tightening. This poses a credibility risk about the inflation target for central banks.
When long term rates are low, stock prices are high. Since future inflation is contained by this “mild hawkish bias”, future long term interest rates are also low, which supports asset prices such as stocks, bonds, and even housing (interest rates and asset prices go in opposite direction).
Central banks around the world seem eager to talk about tightening policy after a decade of record stimulus and now close to full employment (outside the Eurozone). The issue is there is no hurry in terms of inflation, and inflation is their main mandate!
Central bank policy may be wise to at least take into account financial stability and asset prices even without inflation, but that is NOT in their official mandates… But they seem to be implicitly adding this as an “unofficial” mandate in the conduct of their policies.
Maybe the Fed is correct and inflation will gradually rise in 2018–2019, hence that a slow and gradual monetary tightening is warranted to pre-empt the threat and avoid a disruptive policy response, but that remains to be seen. If inflation does NOT resurface, what then? Credibility will start to erode at one point, and markets won’t understand what, exactly, is the central bank aiming for: Inflation at 2%? Lower asset prices? Unemployment at whatever level? What else? For the record, I think the entire craze about inflation targets is way overblown, but that is a long story and does not change what IS.
Maybe the “neutral policy rate” is significantly lower than central banks currently believe? The neutral rate is the rate at which the central bank is not “boosting” nor slowing activity. It seems to be between 0% and 2% in most countries, suggesting the neutral real rate is between 0% and 1% (nominal rate minus inflation).
For now, 3 central banks changed their tone from “neutral / lets-wait-and-see-what-happens-after-a-decade-of-stimulus” to “moderate tightening”:
- USA
- Canada
- UK
Of these 3, the only one I find has a “legitimate” moderately hawkish bias is the Bank of England due to above-target inflation, record low interest rates that have not moved for a long time, and record low unemployment. This is why I am GBP bullish in terms of general trend.
Elusive inflation
Inflation remains elusive, even with all the past monetary stimulus. Why? As I explained in detail in another post, inflation is ultimately created by credit expansion when the economy is hitting limits to production capacity. There are structural forces at play that are containing inflation worldwide:
- Aging populations want to save more and take on less debt.
- Already-indebted households in some countries have limited scope for extra credit accumulation.
- Businesses have been keeping a lid on investment expenditure. This may finally change soon, as capacity utilization indicators are finally approaching “full capacity” levels, suggesting potential for some business credit expansion going forward.
- Governments are seeking to stabilize their fiscal positions, thus keeping a lid on credit expansion from governments going forward.
- Technology, automation, innovation, and global competition in all markets keep a lid on prices and add deflationary forces.
After a huge deleveraging after 2008, the USA has space for private sector credit expansion, hence for inflation going forward, but it seems slow to pick up, and the credit expansion outlook is subdued in other economies.
The conduct of monetary policy going forward
It is important to understand the process of macro policy by central banks. People may think it seems trivial, with small gradual changes to policy rates that everyone knows is happening anyways. The process is significantly more complex, because current asset prices, credit conditions, mortgage rates, production and labor market conditions are all influenced by past, current, and expected future policy. So the central bank must stand today, looking into the future, and must decide on wildly different possible options for the interest rate (and balance sheet), which all have very different outcomes. Communications by central bank officials also greatly influence future expected interest rates, which in turn have an impact on current interest rates, asset prices, currencies, real economic activity, and capital flows.
It could look something like this:
Note that the number of possible options for the policy path is infinite! The same questions arise about the size of the balance sheet. Central banks are more comfy when their policy rate sits comfortably above zero, because it gives them more room to cut the rate in the face of a recession. This is one reason central banks prefer positive inflation (there are many others).
The outcomes for the production, jobs, profits, stocks, bonds, mortgage rates, exchange rates, liquidity conditions, and most everything else are quite different depending on the chosen policy path and the communication that accompanies it. The other question is “what is the neutral rate?” Where should central banks stop increasing the policy rate and move to the sidelines? Is it 1%? 2%? 3%?
Currently, the Fed is signalling a slow and gradual tightening that will likely pause around 2% or 2.5%, accompanied by a slow and gradual shrinking of the balance sheet, all this mostly depending on inflation. The market is having a hard time believing this, perhaps because many analysts do not believe inflation will rise sustainably over the next 2 years.
2 scenarios for stocks, bonds, and currencies for the next year
If inflation rises, the Fed will tighten policy and the market will start believing it. The USD will appreciate and this will add pressure on other currencies (they will depreciate) and add inflation in those countries via import-push inflation, thus forcing those others to also tighten policy, leading to a global policy tightening. This would hit the brakes on stocks, bonds, housing, and commodities, and would add pressure on USD-denominated debts in China and Latin America. These effects may be small due to the relatively mild tightening, unless inflation credibly rises above target for some time.
If inflation fails to materialize, Fed policy may signal a pause in early 2018. The USD would depreciate and looser-than-expected policy might support capital markets and commodities, as well as low pressure on emerging markets.
Eurozone and Japan
France, Spain, Italy, as well as the Eurozone in general still have high unemployment and very low inflation. There remains considerable slack in the Eurozone and although Germany is running at full employment and ECB policy is indeed influenced by Germany, macro policy for the Eurozone is conducted for the Zone as a whole, not for a specific country. There also remains political risk in Europe, with pockets of “separatism” in Spain, anti Euro parties in many countries, and banking sector risk in Italy.
The Eurozone is very far from “out of the woods” and policy is likely to remain slanted towards neutral/accommodative for quite some time. THE risk to the Eurozone was the French election, but with Macron now in power and showing resolve in much-needed reforms, it is safe to say that the Eurozone is no longer in “danger” and should continue to slowly improve over the next several years. Inflation remains very low, although deflation risk now seems out of the way.
Japan is running smoothly, with very low unemployment and still no inflation in sight. It seems Japan just can’t get inflation up to its official target of 2% (stop laughing)…
Japan’s macroeconomics is a lab for the structural forces at play on a global level in the industrialized world, which I discussed at length in many posts.
Profits and stocks
The continued global expansion may see capital flows going towards higher-yielding markets if USD upside remains contained, as price-to-earnings hit their upper limits, but Trump policies may give a second wind to US stock markets for the next year, so this may be a good point to “buy the dips” if the context continues to favour low interest rates, jobs, and business investment.
All in all, I remain bullish on stocks going forward, but beware of currency risk and keep an eye on inflation… My general bias for currencies for 2017Q4 is USD and GBP bullish, CAD bullish/neutral, EUR, AUD, and JPY bearish. Please clap and like to share and show appreciation. Feel free to comment to ask questions or provide extra insights!
Pascal Bedard
pbedard@yourpersonaleconomist.com
