The Fed is making a change. The central bank announced last week that it will shift to “average inflation targeting” instead of using a hard inflation target of 2%. The change provides the Fed with the flexibility to keep interest rates very close to zero even in the event that inflation gets above its previous target of 2%. The new approach represents an acknowledgment that the Fed has very little fear about inflation getting out of hand and therefore may instead use policy to more effectively address its other mandate, which is maximum employment. The Fed had telegraphed the change, and so the markets are taking the news in stride. But that doesn’t necessarily mean that this announcement comes without dramatic implications.
The news of the Fed change started to trickle out about a week before the announcement, and the response so far has largely been a continuation of previous trends. After spiking to very high levels during the initial stages of COVID, the dollar is now trading at a two-year low against a basket of six major world currencies. The dollar’s weakness, in turn, is helping to extend a significant increase in commodity prices. We’ve seen notable increases in the price of: 1) gold, which many investors use as a hedge against inflation; 2) copper, which is a barometer of the global industrial economy; and 3) lumber, which some use to gauge the strength of the housing and construction markets. If the Fed is intent on generating higher inflation, the commodity markets are telling us that the central bank is on the right track.
In the first graph below, we show the recent drop in the dollar and increase in commodity prices. In the second graph, we show that the rebound in commodity prices over the past three months corresponds to a bounce in consumer price levels as measured by the Consumer Price Index (CPI) and the Personal Consumption Expenditures Price Deflator (PCE). However, inflation as measured by these metrics remains far below the Fed’s targets.
On the stock-market front, it’s business as usual. Investors have yet again become emboldened that the Fed is nowhere close to ruining the party by raising interest rates. The indices continue to be led higher by the same handful of FAANG stocks (we include Microsoft) that have now grown to represent about a quarter of the S&P 500’s total market capitalization. Some other names are starting to get in the action – like Zoom, Tesla, Docusign, Nvidia and Salesforce – but by and large this bull market has been characterized by very narrow breadth. The S&P 500 and Nasdaq are trading at all-time highs again even as the economic and political outlooks remain very cloudy. If the Fed wants to see inflation, it need look no farther than the Nasdaq! But as we all have learned, the Fed pretty much ignores asset prices in its assessment of inflation.
The housing market has been one of the more resilient sectors through this downturn. With supply very low, mortgage rates falling below 3%, economic stimulus payments and a moratorium against foreclosures, housing prices have grown consistently each month. Looking ahead, most analysts believe there is a limit to how far mortgage rates will fall. The ability to qualify for a mortgage is also becoming a factor as the labor market remains weak and banks have started to tighten underwriting standards. Some economists are worried that the rise in housing prices and reduced access to credit will lock many first-time buyers out of the market. I think it’s fair to say that is already happening.
But I digress. As defined by the traditional inflation metrics (the Fed likes the PCE, excluding the volatile categories of food & energy), inflation has been deemed too low. There is also considerable skepticism about the Fed’s ability to boost inflation, as measure by the traditional metrics, above 2% anytime soon. The primary reason for the skepticism is that there is so much excess capacity right now. The unemployment rate, down from the nosebleed levels of earlier in the year, remains above the highs experienced during the Global Financial Crisis. Capacity utilization, at just 70.6%, remains very depressed relative to the long-term average of about 77%. Economists generally agree that significant increases in inflation will not be possible until and unless we start to see a reduction in this excess capacity, also referred to as “slack.” Based on the current level of economic slack, we might be waiting for a long time.
But if there’s one thing I’ve learned over the past 30 years, it’s that the Fed usually gets what it wants. The old saw “Don’t fight the Fed” has rarely been such sage advice for equity investors. Throughout the ten-year bull market following the Great Recession, investors (correctly) operated under the assumption that the central bank’s liquidity bazooka is more powerful than either economic fundamentals or valuation concerns. Investors are using the same playbook today as money continues to pour into the market, with the biggest money flows going to some of the most absurdly valued stocks. To be sure, investors piling into stocks like Tesla and Zoom at their current prices are not betting on fundamentals but rather the likelihood that the Fed will keep its foot on the liquidity pedal long enough to sell to someone else at handsome gains. But as Mohammed El-Erian said on CNBC this Wednesday morning, and I paraphrase, you need to understand that you’re making a bet on the Fed’s liquidity rather than fundamentals. Mohammed doesn’t play that game, and neither does Farr, Miller & Washington.
To be clear, we think the Fed did a masterful job of responding to the COVID crisis by ensuring enough liquidity to avoid a nasty financial crisis. The central bank’s quick and decisive decision-making was an essential complement to the massive fiscal response by Congress. But we also believe that too much of a good thing can cause problems. Under Ben Bernanke, the Fed also did a great job in responding to the Global Financial Crisis. However, Bernanke’s Fed also failed to normalize policy after the crisis had passed. We think that failure led to some undesirable outcomes that probably could have been avoided or at least minimized. And though the COVID crisis is far from resolved at this point, it sure seems like a commitment to keeping interest rates at zero from now until infinity is inviting the same type of problems. We think the Fed would be better served by doing the following:
1. Go beyond the traditional inflation metrics and begin to incorporate the impact of 1) rising asset prices (real estate, stocks and bonds), and 2) disproportionate growth in prices for non-discretionary goods and services (housing, health care, child care, education), which account for a much larger percentage of expenditures for low- to moderate-income folks.
2. Consider the impact of rising housing prices and tightening credit conditions on first-time homebuyers.
3. Be more aware of the signals provided by the capital markets; for instance, does the spike in gold prices represent a possible future surge in inflation?
4. Consider the vast accumulation of debt, especially by the federal government and corporations, that has been made possible by ultra-easy money.
5. Consider the makeup of that debt, especially the huge increases in categories like leveraged lending and BBB-rated securities.
6. And perhaps most important, evaluate the impact of monetary policy on economic inequality, which has gotten much worse over the past couple of decades and which we believe is a major impediment to more robust economic growth.
We’re not alone in thinking the Fed has overstepped its bounds in the past and is at risk of doing so again. The Wall Street Journal’s editorial board certainly thinks that’s a possibility. An August 27th article in the Journal read:
“Well, what if there’s nothing natural about falling growth because the Fed’s policies are causing it? Research suggests sustained low rates can dent an economy’s growth potential by steering investment to unproductive uses, sustaining zombie companies, rewarding corporate financial engineering instead of capital expenditure, and contributing to asset booms and busts. It’s a shame the Fed has decided to double down on its low-rate, quantitative-easing bets before such a self-examination.”
My sentiments exactly! When the Fed announced its decision to switch to average inflation targeting, Chairman Powell suggested that the new approach will be more likely to benefit the less well-to-do. He said that under the new model, a decrease in unemployment to very low levels will not automatically result in Fed interest-rate hikes (to ward off inflation). The willingness to accept more inflation would, in theory, allow wages to grow faster and lift up the low- to middle-income folks who have been stuck in neutral for 2-3 decades now. It’s a nice theory. But we first need to get from the current 10.2% unemployment rate back to below full employment (around 4%). The notion that we can do that without causing major side effects is fantastical. Does the Fed really think it can keep the pedal to the metal for several more years without causing major market distortions like those listed by the Journal’s editorial board?
Stick to the program. Maintain your discipline by not chasing the high fliers that your neighbors and friends are talking about. Know what you own, and stick to quality.