The Fed: Red light, green light
Central banks took desperate measures broadly in concert during the pandemic, committing everything they have to easy policy. In recent weeks, much like the first challenge in the hit South Korean show Squid Game, the guidance they have offered markets has been unceremoniously rubbed out.
The trigger is inflation – currently a global problem, largely driven by supply disruptions lifting the price of tradeable goods. But central banks have chosen different strategies to reach their goals. The question is, which ones have lost their marbles?
There have been a number of surprises across several markets. Poland and the Czech Republic have delivered much bigger rate hikes than expected, while announcements from the Bank of Canada and Reserve Bank of Australia have prompted markets to bring forward sharply their expectations for lift-off. In contrast, the European Central Bank has been keen to talk down expectations of a premature tightening. The Bank of England has been in a tug of war throwing economist forecasts in both directions.
Only the Federal Reserve (Fed) has managed to maintain a relatively smooth communication and so there was little reaction to its decision last week to begin the well-telegraphed tapering of asset purchases.
The message from the Federal Open Market Committee (FOMC) statement and Chair Jerome Powell’s press conference is that the Fed prefers to be patient. The central bank accepts that inflation might remain high for some time. Indeed, the definition of transitory has been shifted to imply no long-lasting impact, rather than being over quickly. The Fed has also more explicitly linked the role of the pandemic in creating the supply disruptions which have caused today’s inflation. Powell went on to explain that while there is uncertainty about how long the disruptions last, they will eventually ease.
The Fed does not believe the economy is currently close to maximum employment; this is the key criterion for lift-off. Powell cited the experience of the last cycle, when labour utilisation exceeded expectations without triggering significantly stronger wage growth or inflation. So there is a strong desire to wait to see how the labour market and inflation perform as the impact of the pandemic fades, and after supply disruptions ease, before taking a decision on rates.
This means the hurdle to change tapering’s pace is high and a rate hike in the first half of next year is unlikely, in our view. The most likely trigger for an earlier pivot would be if inflation expectations moved significantly higher.
However, maximum employment could be reached sooner than expected as positive wealth effects from moves in asset prices not only encourage higher future spending, but also reduce the incentive to work and lead to early retirement. In other words, labour force participation might not recover as much as hoped.
With the economy likely to continue to grow above trend, maximum employment could be reached in the second half of 2022. By this point, a deeply negative real interest rate could prove inappropriate. It is not that the Fed is dogmatic. Powell expressed plenty of humility around the difficulty in forecasting after such a unique shock. But because of this uncertainty, and the low inflation experience of the last cycle, the FOMC prefers to wait for as long as possible than risk tightening prematurely.
We worry that the Fed is leading the markets down a glass bridge, which could eventually shatter. Our research suggests the US economy is not particularly sensitive to higher rates. By delaying rate hikes, we believe the Fed risks falling behind the curve and will probably need to go faster and further when lift-off likely begins in the second half of next year.