Jay Powell – musings of a back-seat driver?
Can the markets tolerate higher inflations and therefore higher bond yields without becoming ‘disorderly’? The RWC Diversified Return team explore the conversation from this week’s Fed meeting.
- It is tempting to look at central banks in one of two ways: that they are proactive (part of the solution) or reactive (part of the problem). For the US Federal reserve, 2020 provided moments of both. In May, Chairman Jay Powell took a victory lap on the 60 Minutes show, telling the world how the Fed once again saved the day, had it in the bag, stood ready to keep helping the recovery and so on. A few months earlier in March, successive Sunday-night announcements of emergency quantitative easing (QE) and funding facilities had more than just a whiff of a Frank Drebin, Naked Gun-style omnishambles. The interesting question to ask is whether at what appears to be either peak adulation or peak vilification for central banks, has the locus of power, both for markets and the economy more generally, moved elsewhere?
Jay Powell – glorious reflator of the US stock market, or fumbler-in-chief?
Source: RWC, for illustrative purposes only
- While it certainly feels a bit samey, macro reportage these days revolves around central bank activity and, therefore, around central banks’ policy meetings and press conferences. Despite the daily chitter-chatter from central bank board members, policy changes still tend to be announced after policy meetings, making the ritual of the presser the key part of the central bank liturgy.
- Jay Powell of the Fed was up this week, and the FOMC press conference on the 17th March went quite well for him, in the sense that for once he didn’t crash the US stock market when he spoke. He said the Fed saw 6.5% GDP growth in 2021 (vs. 4.2% previously). While inflation was marked higher (2.4% PCE for 2021 vs. a 1.8% estimate previously), it would remain just above the target 2% level thereafter (2% in 2022 and 2.1% in 2023). He again reemphasised that there would be no rate hikes or tapering of quantitative easing until full employment was resumed. Unemployment would fall to 6.2% at the end of 2021, to 4.5% by 2022 and to 3.2% by 2023. He added that monetary policy was “in a good place”.
- The question of inflation was brought up a number of times in the press conference, and Powell made the Fed’s stance very clear. While they were expecting inflation in the short term, and there might be upside to inflation prints if consumer spending picked up further (especially in the context of ongoing supply-side constraints), such moves would be transitory, as inflation expectations were well anchored at the long-term level of 2%.
- US bond yields have risen sharply in 2021, and the yield curve has steepened with 10-year and 30-year treasury bond yields having risen far more sharply than short-end maturities. This is mainly due to inflation expectations rising, although the growing US deficit also puts pressure on bond prices as the supply of paper increases. When asked about yield-curve control or another ‘operation twist’ (the Fed selling short-dated bonds to buy longer maturities to flatten the yield curve at the long end), Powell said that monetary policy was “currently appropriate” and that policy would only by changed by “disorderly market conditions”. Proactive or reactive? This all seems fair enough so far.
- To some extent, the market backs up this view that inflation is transitory. Inflation is itself a year-on-year calculation whose growth is predicate on base effects (a comparison to the previous year’s data). We already know inflation prints for April, May and June are going to be high because the equivalent prints for 2020 were so low due to the global lockdown. The Fed clearly thinks that these base effects, along with the temporary nature of supply-side constraints, are the reason to believe that any inflation rises will only be passing. One could add that the massive global stock of debt has, is, and will be deflationary, and the market clearly knows this (Japanese rates are still only just above zero for 10-year JGBs, Germany still has negative yields on 10-year bunds and so on).
- The bond market is also pricing in more short-term inflation than long-term inflation. This can be clearly seen in the graph below which shows 5-year inflation break-evens (blue) at 2.64% while 10-year break evens (yellow) are at 2.31%, and the gap between the two has increased in 2021. While we might get more inflation in the short-term, the effect on long-term inflation expectations is more muted.
- Jay Powell once again made the Fed’s stance abundantly clear. Employment is clearly the key dynamic for them at present, and despite headline unemployment levels having fallen, Powell once again emphasised that a full 9.5 million more Americans were unemployed in 2021 as compared to pre-pandemic 2020. The Fed will not hike rates nor taper QE until employment returns to these lower levels. The Fed dots (individual board members’ estimates of rate-hike timing) shows a median of a first hike in 2023, which is a long way off. This is the Fed in proactive mode.
- The Fed’s medium-term inflation target is 2%, and in 2020 they changed their policy stance by saying they were willing to tolerate higher-than-target inflation in the short term in order to make up for prior periods of below-target inflation. What is interesting is that 5-year break-evens are already at 2.64%, and while 10yr break-evens may be lower, a further rise in 5yr inflation expectations may yet drag 10-year expectations higher. This is in numerical terms what a de-anchoring of inflation expectations would amount to. This is really not what the Fed wants. They really need this inflation to be transitory.
- This is where the question of whether central banks are really in control, or whether they are really the locus of power any more comes into question. According to IMF data, the US finished 2020 with a debt-to-GDP ratio of 105.2%. With a $0.9tn Covid-19 relief bill in December 2020, another $1.9tn in March, potentially a $2-3tn infrastructure bill in the fall, the US deficit could end up somewhere between 15% and 20% of GDP in 2020. Not only is the stock of debt high already, it is rising quickly, and rising yields in the US bond market, whether from a reflationary recovery, an inflationary surge, or just in anticipation of a huge US deficit, spell a funding issue for the US government. There is a point when funding the deficit becomes a potential solvency issue, particularly if tax receipts fail to cover both the deficit and the interest cost.
- Any one country which borrows in its own currency need not default as the central bank can always create enough money to avoid the default event. While this process may eventually be inflationary, it is still an a priori fact that money printing can avert default (the Russian default of 1998 is in many ways the exception that proves the rule – they defaulted on ruble-denominated debt with no need). This principle is a core one for modern monetary theory in that it justifies any amount of government spending (so long as it is not inflationary). In this sense, the Fed can always step in (with QE, or yield-curve control which is backed up by QE) to cap US treasury yields and keep the US government solvent.
- The US now finds itself in a very different situation to 2009. Unlike 2009, bank solvency is not an issue in 2021. Jay Powell hinted that there would soon be a policy announcement not only on bank dividends and stock buy backs, but also on the supplementary lending ratio (SLR), a prudential measure which limits the size of bank balance sheets relative to their capital. Unlike 2009, there is no urge towards austerity. Biden’s White House is hinting at tax hikes, possibly for corporates and high net-worth individuals, but deficit spending is very much in vogue following 2020’s furloughs and other government handouts. Fiscal policy is doing the lifting, and this is likely to continue so long as the US is trying to recover from the pandemic, especially if pre-pandemic employment levels are viewed as a shared policy goal. This makes the Fed into a support act, and thus reactive not proactive.
- Aggressive fiscal spending means primary deficits and a rising stock of debt. There are strong reasons to believe that any situation of over-indebtedness is inherently deflationary, and that deficit spending in this situation rarely results in really strong GDP growth, especially if the spending is of the pork-barrel government variety. Japan is cited as the perfect example of this, especially with respect to the failure of public works to rekindle inflation expectations or a self-sustaining economic recovery. What ought to be noted though is that for much of the 1990s, government spending happened in the absence of QE from the Bank of Japan, and therefore there was net credit tightening, hence ongoing deflation and no recovery. The key difference in 2020-1 is that the US is deficit spending while the Fed is doing QE. If the US sees a net expansion of credit, then the outcome may be a desirable reflation. The risk is it becomes inflationary.
- There seems to be a split personality issue in markets at the moment. The rapidly rising stock of debt, the fall in the gold price and rally in the US dollar in 2021 all suggest that inflation is temporary and that pretty soon we’ll be back to falling yields and disinflation (potentially outright deflation if the dollar rises far enough). Yet the commodity market is screaming inflation. The graph below shows the Commodity Research Bureau’s US spot raw materials index rocketing higher, even when the US is still far from being fully open post pandemic.
- If you have a situation where on the one hand gold and the dollar are suggesting deflation while on the other commodities are shouting inflation, clearly there is something very strange going on. Rather than the Fed being in charge, or even the US Government, it is perhaps now the case that it is in fact debt which is driving the car.
- Even the slightest hint of inflation is starting to push bond yields to levels where deficit funding and interest payments start to get onerous. The increase in M2 in 2020-1 was epic (~$4tn from the end of 2019 to Feb 2021, or around a quarter of GDP). If anything was going to create inflation, this increase in M2 would. It is kind of a now or never moment for monetary inflation. The question is now whether the market (equity, credit and bond) can tolerate higher inflation and therefore higher bond yields without becoming ‘disorderly’ (to use Jay Powell’s terminology). If this answer is no, then the Fed may be forced into further measures like yield-curve control – i.e. anything but the normal policy response to rising inflation which would be to hike rates. That might be the point at which the phrase ‘regime change’ might start to get used a bit more.