US Federal Reserve monetary policy continues to play an outsized role in directing the near-term trajectory for the global economy. US monetary policy impacts the domestic economy, the global economy and the financial markets. Risk assets have been the biggest beneficiary of US monetary policy and will likely be the biggest losers when the support ends.
In late August, Fed Chair Jerome Powell reinforced his dovish outlook for US inflationary risks, the trajectory for tapering, and future interest rate policy in a speech at the virtual symposium in Jackson Hole. He said the conditions to taper $120 billion asset purchases (specifically, $80 billion in US treasuries and $40 billion mortgage-backed securities per month) had been met.
Powell was clear: the US will start to taper asset purchases, but not immediately due to economic headwinds related to a surge of the Delta variant in the US. However, Powell insisted that the start of asset tapering, and its conclusion, should not be interpreted as a precursor to interest rate increases as these were different policy decisions, governed by independent criteria. The taper timeline will be data-dependent, while the market consensus appears to favour late Q4 and no increase in interest rates until 2023 at the earliest. The Fed’s policy has both supporters who appreciate the benefit of accommodative policy on risk assets, and detractors who believe the US economy no longer needs central bank emergency support.
The ‘transitory’ inflation axiom divides economists. After the first pandemic wave, the rapid reopening of the US economy brought a sharp recovery in GDP and a run-up in inflation. US GDP has surpassed its pre-pandemic level, accelerating at 6.5% on an annualised basis in Q2, although the momentum of recovery has probably peaked. Over the 12 months to July, headline inflation soared to 4.2% – well above the Fed’s 2% long-run objective. Businesses widely report upward pressure in commodities due to supply chains disruptions and labour wage increases. However, the Fed is convinced that the elevated inflationary readings will prove transitory, not permanent, and inflation will remain anchored to the central banks’ long-term target level (at or close to 2%).
The Fed argues US inflationary pressures are narrowly focused (e.g. on durable goods and energy prices) or increasing at a pace consistent with long-term inflation objectives (e.g. wage inflation). In contrast, some prices remain sharply lower than the pre-pandemic levels (e.g. hotel rooms and airline tickets). Moreover, global disinflationary forces (e.g. technology, globalisation, demographics, and central banks’ priority to maintain price stability) will continue to weigh on inflation over the long term.
Critics have several disagreements with the Fed’s outlook, which could ultimately result in a policy error and create the potential for a policy U-turn. First, it is argued that inflationary pressures will be persistent and higher than assumed. If future inflation data keeps showing upward momentum, the issue of increased interest rates will continue to sporadically roil markets with the brunt felt by risk assets. In such a scenario of rising inflation, the question for the Fed would be how high does inflation have to reach, and for how long, to invalidate the transitory narrative and prompt a rate increase? More broadly, critics claim that the challenges faced by the US economy are supply-based (e.g. supply chain disruptions pushing up prices), not demand, and quantitative easing (QE) is not a suitable support mechanism for an economy suffering from supply shocks. In this context, it is not explicitly clear that asset purchasing, and ultra-low interest rates helps the economy when the balance of crosswinds are measured. Overall, the Fed’s policy decouples asset prices and markets from the real economy, which can worsen inequality and increase the risk of financial instability. Ultimately, the danger is a policy error that the Fed may not realise until inflation data released later in the year shows objectively that price increases have persisted and broadened out. In such a scenario, it is feared that the Fed may be forced into an abrupt U-turn for which markets are unprepared.
Historically, whenever the Fed has attempted to taper or slow down its balance sheet expansion, volatility has spiked, as investors start to get nervous when the Fed starts to change policy. We have not seen that nervousness emerge this time around. This is either complacency or well-supported confidence, depending on which side of the fence one falls. These opposing macro narratives have played out in volatility in US treasuries over the summer.
Notwithstanding criticism of the Fed’s approach, last week’s jobs report provided further support for the Fed’s dovish approach. Given the Fed’s conviction that the inflation objective remains on course, the focus is squarely on achieving maximum employment which has increased the significance of the weekly US jobs reports as a proxy for the potential start of tapering. In August, 235,000 jobs were created – the shallowest gain for seven months and significantly below expectations as rising infection rates hit the food, retail and hospitality sectors hard, according to the US Labor Department. The unemployment rate improved by a modest 20 basis points to 5.2% in August. The big data miss also suggests the Delta variant is slowing job creation and arguably justifies the Fed’s approach. The payroll report is all but certain to push Federal Reserve policymakers to delay the start of tapering until November at the earliest, market consensus would suggest, as central bankers wait for further job gains before starting to slow bond buying. Many distortions can influence what jobs return, in which sectors, and what the data ultimately says about the strength of the underlying economy.
When the taper timeline is announced it is likely to be bullish for the value of the US dollar, which implies volatility for risk assets. Therefore, do not discount some late autumn volatility in US markets. And, of course, how much the Delta variant continues to stifle economic growth remains the most significant known unknown.
The trajectory of the US economy will drive global growth for the remainder of the year, particularly given the current weakness in China’s economy due to the delta variant and the ongoing regulatory reforms. From the perspective of the UK economy, accommodative Fed policy will be supportive for UK exports. Over the remainder of the year, the dollar is likely to remain range-bound but will strengthen after the tapering timeline is announced; until then, the dollar will be weak against sterling. Elsewhere, US capital is expected to return to the UK economy. For example, in the commercial property sector, US private equity capital notably returned in the second-quarter, lured back due to post-Brexit political certainty and the UK’s relative pricing advantage over core European markets.
If any of these issues relate to your business or a portfolio company and you would like to discuss your options further, please get in touch with one of our team.