How it started
In 1906 there was a massive earthquake in San Francisco. The shaking and fires that followed destroyed over 80% of the city. It was one of the deadliest earthquakes in US history. Insurance companies faced staggering claims from policyholders. Many of those insuring companies were from the UK. Yet, at the beginning of the 20th-century, the capital was not flowing as freely as today. Large transfers of gold had consequences on the entire system. The British monetary authority had to increase interest rates to compensate for the outflow of capital. Tighter financial conditions that began in Europe had a similar impact in the US the year after. Lack of available loans led to market distress and ended up in what we call – The Panic of 1907 – a short but intense sell-off in the American stock exchange.
The event initiated a discussion about the structure of the financial framework in the US. In 1913 it resulted in creating the Federal Reserve Bank. Its main task was to prevent panic sell-offs in the markets. It took over the central bank’s role in the US and is now the most powerful financial institution globally.
How it is going
Over a hundred years later, we are at a point when the Fed became the victim of its own success. Every time the markets are selling off aggressively, it is coming to the rescue. It proved successful in putting the floor to market moves, and it was no different in 2020. But everything has its cost. The main side effect of the Fed’s policy is an enormous build-up of debt.
The current situation is far from comfortable. Seemingly everything seems to be working. Growth expectations are rising. The labour market is improving. Inflation expectations trend higher (which is a good sign after the recession). In August 2020, the Fed announced its policy change towards average inflation targeting, and the market has been repricing its inflation expectations accordingly.
If it is so good why are we worried?
Over the last two months, we have seen an acceleration of inflation expectations and a significant rise in bond yields. There were three main triggers: Georgia elections won by Democrats taking control of the Senate and paving the way for a Blue Sweep (a situation when Democrats hold power in both the White House and Congress), Biden’s stimulus plans, and successful vaccination roll-out.
None of those events is worrisome in isolation. However, the implications of ultra-loose monetary policy, a large increase in government spending and a potential boom in consumer spending after lockdowns are lifted could all add up to a powerful combination. That is the main worry of prominent economists like Summers (https://www.washingtonpost.com/opinions/2021/02/04/larry-summers-biden-covid-stimulus/) or Blanchard (https://www.piie.com/blogs/realtime-economic-issues-watch/defense-concerns-over-19-trillion-relief-plan), who are very vocal that the US economy can be overheating very soon.
Fed’s options
Since the 1970s, we haven’t had problems with inflation in the US. Some policymakers believe it will be tough to get a meaningful rise in consumer prices regardless of what they are doing. They might be right. But the problem with inflation is similar to glasses of wine – you only know when you had too much after you drank it. If the Fed lets inflation go too high, it might be very costly to fight with it later.
Another risk that markets are equally worried about is if the Fed decides to step in too early (i.e., signalling a potential tightening of its policy). Such a step would definitely calm inflation worries, but it would greatly shock the financial system. The valuation of almost every asset right now is reliant on cheap funding. This is the Fed’s successful policy’s side effect – the massive leverage of the global financial system. Each subsequent monetary stimulus led to a rapidly increasing level of financialization of the economy. Higher rates would cause great problems in servicing the debt for many governments and companies.
There is also a third option the Fed could choose – the yield curve control. In short, it means that the central bank would impose control on the price of bonds. The yields would be capped at a certain level and not allowed to go higher. There are, however, no free lunches in the economy as we know. Such policy would be nothing else as financial repression put on the US’s financial sector and could lead to many undesired consequences (like the sudden drop in the value of the US dollar).
Clearly, there are no easy options as we advance. And investors are increasingly uneasy with growing uncertainty.
Economy or credibility
So far, the Fed is confidently allowing markets to reprice growth and inflation expectations higher as a healthy sign. It’s quite easy as inflation worries are only a hypothetical discussion, and there is no evidence suggesting inflation will indeed be much higher.
When it becomes more challenging for the Fed to communicate its stance and control inflation, expectations will come in 2Q. By that time, inflation is expected to rise sharply, mainly due to large base effects (see where oil prices were one year ago). Inflation might also get a boost from the already mentioned pent-up demand. People are likely to start spending their disproportionately high savings on goods and services unavailable during the pandemic. That can create a large demand spike at a time when supply is restricted by many technical issues (see what is happening with semiconductors or shipping costs).
Communicating to investors how they will maintain credibility and anchor inflation expectations without causing market havoc will be the uttermost challenge for Fed officials soon. Any potential hint of tightening would cause a large reversal in sentiment on many markets causing financial conditions to tighten (perhaps prematurely).
Long term inflation
I am still sceptical about long term inflation moving considerably higher (despite obvious worries about inflation near term). Firstly, there are still structural forces at play that will prevent considerably higher inflation which I discussed here (https://www.fintaste.com/are-we-heading-into-much-higher-inflation/). Secondly, it is unclear how big is the so-called output gap in the economy. Some economists argue it is still large, and even high growth will not cause overheating (https://stayathomemacro.substack.com/p/why-talk-about-inflation). And lastly, although the current spending plans are large by any account, they should still be transitory. Nobody projects deficits in the US (or anywhere else) to remain at such high levels as in 2020/2021. If spending reverses, so should inflation pressures (https://www.piie.com/blogs/realtime-economic-issues-watch/inflation-fears-and-biden-stimulus-look-korean-war-not-vietnam).
Having said all that, I do expect high volatility in all markets going forward. Bonds might be under constant pressure from inflation worries on the one hand and fear of the Fed tapering on the other hand.
It will be interesting to watch how the Fed copes with its mandate set up in 1913. Will it save the markets again when needed?