Is the Federal Reserve really in control?

The bull case for markets is based on the twin propositions that the Fed is in control and that it will continue to offer extraordinary amounts of support. Worries about both are the cause of volatility.

| 5 min read

Whenever investors have a rush of doubt over inflationary pressures or the possibility the Fed might start to reduce its assistance, there are short, sharp sell-offs in riskier assets.

The Fed is very clear about what it is trying to do. It is working closely with the Biden Administration on a huge joint stimulus of fast-money growth and extra government spending to get the US back to work. The main things they jointly watch are unemployment data, withdrawal from the labour market, and the inequalities around employment and pay. The aim is to boost pay at the lower end, and to cut the relatively high unemployment of groups such as African Americans and Hispanics, whilst also bringing the average unemployment rate down.

The Fed believes that it can help do this without lifting longer-term inflation expectations. It accepts that, in the shorter term, inflation will rise and move above its 2% target. It is happy to see a period of inflation a bit ahead of 2% to bring the average closer to 2% after a period of below-target inflation. Many in the markets think this will be possible. They also agree with the Fed this means no early moves to reduce its money creation and bond-buying, let alone putting up interest rates. This remains our base case.

In the past, the Fed has had equally clear views of how things are and what they should do. In May 2013 when recovery from the banking crash was well advanced the Fed hinted at tapering its bond-buying, leading to the taper tantrum bond sell-off. Shares subsequently made good progress over the balance of that year with the Fed not actually ending its bond-buying. The short-term market pain was increased by a rise in real yields as well as in nominal yields as bonds sold off.

In October 2017, the Fed was determined to slim its balance sheet to make the point that past quantitative easing was exceptional, and to give them more room to manoeuvre should there be a future crisis. it gradually reduced its balance sheet holdings of bonds from $4.5tn to $3.8tn over the following two years.

Market intervenes

The markets thought cutting the officially-owned bonds was too tough and gradually forced the hands of the Fed into staying the reduction of its bond holdings. At first, the Fed seemed perplexed or even hurt that investors could disagree with it and could not see what harm balance sheet slimming was doing. Then, in September 2019 before the pandemic, the Fed conceded. Ten-year Treasury yields were driven up from 2.2% to 3.2% by October 2018 but subsided in 2019 in anticipation of a change of stance.

Today, markets have accepted the need for some monetary tightening in Canada and the UK, where the central banks have already announced tapers to their bond-buying, despite the fact that US money growth and support is considerably larger proportionately than in other advanced economies. Past experience of tapers demonstrates that shares can recover and make progress with a steeper yield curve as long as the growth of earnings and the wider economy continues, even if the first-round effect is negative on prices.

Dissent in the Fed

In the latest Fed minutes, there are the first signs of dissent and concern that the central view may be too optimistic. It now tells us the inflationary increases “largely reflected transitory factors” and have removed the word “considerable” from the downside risks. They agreed “risk appetite in capital markets is elevated” and we learn that two members of the Committee worry about “inflationary pressures building up to unwelcome levels before they become sufficiently evident to induce a policy reaction”. More than two members mentioned upside risks to inflation. They also discussed the timing of when they will discuss a plan to taper.

The Fed’s small band of critics argue money is too loose and point to the rise in five-year inflation expectations to 2.7%, as measured by the indexed securities, and to the general surveys showing consumer worries about inflation going above 3%. The Fed assures us inflation expectations matter to it in policy formation and it still thinks they are well anchored. This is the measure to watch.

On past evidence, we have to allow for the possibility that the Fed may not remain in control of markets – and the inflation narrative – as they are today. Whilst any tightening will have short-term adverse effects on shares, thereafter it will depend on how much growth there is in real earnings of companies and in the economy as a whole. Private-sector lending and credit creation might well take over from central-bank money. The tightening would, of course, include yield curve steepening with losses on longer-dated bonds.

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Is the Federal Reserve really in control?

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