Turbulence defines today’s investment environment, with great waves of uncertainty surging from the pandemic, the election, fiscal policy and a slowdown in what had been, to this point, a sharp recovery from a very deep recession. But amidst the tumult, investors should not neglect the crucial role of interest rates. The waves of uncertainty should fade in 2021 and, as they do so, the primary role of interest rates in determining asset class returns should reassert itself.
For this reason, even in this very noisy environment, investors should pay attention to the Federal Reserve’s latest pronouncements on monetary policy. In particular, it’s important to understand what Fed officials have said about the conditions under which they might raise short-term interest rates, taper bond purchases and eventually move away from an accommodative policy. It is also worth exploring the rationale behind this timetable. However, from a practical perspective, it is perhaps most important to ask if some of those conditions could be met earlier than the Fed and the market expect and what that might mean for short-term rates, long-term rates and financial assets in general.
New Guideposts on Monetary Policy
In late August, the Federal Reserve announced its new policy of “average inflation targeting”. This policy is aimed at achieving higher inflation over time, in part, by raising inflation expectations in the economy. The Fed is attempting to do this by explicitly letting inflation run above its 2% target for a while to compensate for recent years when it has fallen short of this goal.
The September FOMC statement provided further clarity on what this would mean for monetary policy. Translating from their slightly convoluted language:
- The Fed expects to keep the federal funds rate in its current range of 0-0.25% until inflation (as measured by the personal consumption deflator) has risen to 2% and is on track to exceed 2% for some time and until labor market conditions have reached levels which they regard as consistent with full employment. This labor market requirement is vague but seems, based on Jay Powell’s press conference comments, to encompass achieving the Fed’s long-term unemployment projection of 4.1% along with higher labor force participation and stronger wage growth.
- Even after the Fed has started to raise short-term interest rates, monetary policy will remain accommodative until inflation has actually exceeded 2% for some time, and.
- Over the coming months, the Fed will continue to buy Treasuries and mortgage-backed securities at at least the current pace to sustain smooth market functioning and help foster accommodative financial conditions. The current pace is net purchases of roughly $80 billion per month for Treasuries and $40 billion per month for mortgage backed securities.
Such is the conditional timetable that the FOMC has established for itself. Moreover, it also provided an expected chronological timetable in the Summary of Economic Projections (SEP) released in conjunction with its September meeting. In particular, the median projection of the members of the FOMC is that inflation will not rise to 2.0% and unemployment will not fall to 4.0% until the fourth quarter of 2023. Consequently, the median projection of FOMC members is that the Fed will not raise the federal funds rate until 2024 at the earliest. It should also be noted that these forecasts are broadly in line with private sector economic forecasts and the fed funds futures market.
Potential Problems with the Timetable
There is no doubt that low interest rates are appropriate for today’s economy and, in fairness, any long-term monetary strategy would have its weaknesses. However, there are a number of problems with this strategy that need to be recognized.
First, it pays no attention to the continual inflation of asset prices relative to consumer prices. Over the past 30 years, the ratio of total U.S. financial assets to GDP has doubled to roughly 5.5 times, reflecting the combined impacts of low inflation and easy money in boosting both stock and bond prices. While this is not, as of now, generating a concentrated asset bubble such as emerged in tech stocks in the late 1990s or real estate in the mid-2000s, it does leave markets and the economy vulnerable to a sudden broad slide in asset prices.
Second, the Fed’s statement of “willingness to continue to buy Treasuries at at least the current pace over the next few months” probably understates what the Fed would have to do to hold long-term interest rates in check. Current negotiations on an additional coronavirus relief bill are stalled and may not yield an agreement before the election. However, a bill priced at between $1 and $2 trillion could well pass in the Congress in the lame duck session after the election. In addition, a further fiscal stimulus package could pass early next year with the installation of a new Congress. While some of the spending increases and tax cuts would likely occur beyond the current fiscal year (which runs from October 1st, 2020 to September 30th, 2021), it is reasonable to assume that these bills will add at least $1 trillion to this year’s deficit.
This deficit was already on track to be the second largest in U.S. history, smaller only than the $3.1 trillion deficit racked up in the fiscal year that ended 10 days ago. In fact, in September, the Congressional Budget Office forecast a total shortfall for fiscal 2021 of $1.8 trillion. If the federal government adds a further $1 trillion to this deficit, the Fed’s current pace of Treasury purchases, which amount to an annual pace of roughly $1 trillion, would likely prove insufficient to prevent an increase in long-term interest rates, as U.S. government borrowing strained the resources of global savers in a recovering global economy.
Third, there is the distinct risk that inflation arrives earlier than the Fed expects.
September CPI data, due out on Tuesday, should confirm that inflation continues to recover from its slump earlier this year, with headline CPI expected to rise by 1.5% year-over-year and core CPI rising by 1.9% year-over-year. We estimate that this should translate into year-over-year headline and core consumption deflator inflation readings of 1.6% and 1.8% respectively for the month of September.
While these numbers remain below the Fed’s 2% goal, we think it is likely that they will jump to more than 2% year-over-year by the second quarter of next year, reflecting the significant drop in inflation recorded in the second quarter of this year. Thereafter, both progress in the economy and the pace of inflation depend on whether the widespread distribution of a Covid-19 vaccine can allow normal life to resume.
If this does occur, it is likely that consumer demand for restaurants, leisure, entertainment and travel will all explode, exceeding the ability of very battered industries to supply those services. This could sustain consumption deflator inflation at a pace of well over 2% year-over-year for the rest of 2021 and into 2022.
It should also be noted, however, that the unemployment rate, while falling rapidly in the second half of 2021, would likely remain above the Fed’s 4.1% long-term projection well into 2022. The history of U.S. expansions has always shown that the unemployment rate falls more slowly as the economy approaches full employment since the hardest-to-place workers take longer to find employment.
Prospects for a Steeper Yield Curve
This would, of course, be well in advance of the timetable envisioned by either the Fed or markets. Taking the Fed’s guidance literally, it would seem to meet the inflation condition for raising the federal funds rate. However, with the labor market still healing, the Fed could postpone any rate increase until 2022 at the earliest. Indeed, if the Fed were to raise the federal funds rate in 2021 without meeting their stated labor market condition, they would undermine the whole concept of forward guidance.
However, the Fed has deliberately given itself some flexibility with regard to its balance sheet and it could easily taper its Treasury purchases during 2021 in recognition of slightly hotter inflation and a more buoyant recovery than they anticipated.
If this transpires, then strong Treasury issuance, diminishing Fed purchases, higher underlying inflation and an improving economy would all conspire to boost long-term interest rates, even as the Fed held overnight rates in check.
For investors, this type of environment should favor stocks over bonds. Within the bond market, it could diminish credit risk but hurt long-duration bonds. Within the stock market, it could be positive for value stocks relative to growth stocks and, in particular, favor financials because of higher net interest margins.
All of this would represent a sea-change for financial markets which have seen the best gains, on a year-to-date basis, in long-term government bonds and large-cap growth stocks. It must be emphasized that it depends on three crucial assumptions, namely, that the federal government remains in a fiscally expansionary mode after the election, that a successful vaccine is developed and distributed and that the Federal Reserve adheres to the conditional timetable it has now laid out. So while this scenario suggests that investors should prepare themselves for a steeper yield curve, the uncertainty of the outlook continues to underscore the advisability of broad diversification.