David Roberts

What the Fed’s new ‘flexible’ inflation approach means for bond investors

David Roberts

For a decade or so, most G7 central banks have used a single point inflation target as a core mechanism to guide investors and manage monetary policy. The wisdom of such a mechanism has often been questioned and the US Federal Reserve recently became the latest central bank to water down inflation targeting in its approach to economic management. Its new policy of flexible average inflation targeting has raised questions about whether it has adopted Modern Monetary Theory (MMT).

After a review of its modus operandi, the start of which predated the Covid-19 crisis, the Fed concluded that its focus should be on reducing any deviation below full employment (“assessments of the shortfalls of employment from its maximum level”) and that it should switch to an average inflation target (“following periods when inflation has been running persistently below 2%, appropriate monetary policy will likely aim to achieve inflation moderately above 2% for some time”).

Unemployment is key. With many looking for a job, and following a period of below-target inflation, folk are of the opinion the Fed will let the economy run “hotter” than previously expected for the foreseeable future. This clearly has implications for the fixed income markets.

Long-dated bonds are less valuable. Rising inflation expectations, assuming the Fed is successful, means the real worth of a nominal fixed income stream declines. Investors demand more interest, so the price of fixed income bonds falls, as does the value of equity dividends or any other projected cash flow.

Earnings are a “nominal” concept – higher inflation should create higher nominal earnings and boost stock prices, even if inflation erodes the real value. So, if inflation is cumulatively 100% in the next decade, Netflix should be priced at twice the level in 10 years as it is now (of course, its real worth remains the same). Clearly sectors and companies with pricing power will win out.

But we’ve been here before. For a decade since the financial crisis, central banks have used aggressive policy to hammer down the price of money without much evidence of increasing general prices.

This is perhaps where MMT comes in. Parts of this new policy have the market convinced that Fed Chair Jay Powell has decided to adopt MMT, an alternative economic theory that downplays the role of traditional monetary policy (basically interest rate changes) in economic management. It’s the theory that governments should print and spend as much money as they like to push the economy to full employment and thereby stimulate growth by running a big deficit, funded by printing money. Go and buy a bridge and get some folk to build it. Those workers  then take their salaries and spend them on other stuff, thereby kick-starting the economy and boosting employment further. If the economy runs too hot, raise taxes rather than play with interest rates.

Can that work? It sounds simple. First, you need spare capacity: are there bridge builders waiting to be employed? If not, you risk “crowding out” other investments. So far, so good, as the US has lots of people; possibly some are skilled bridge builders.

Second, you need a fiat currency: print your own money and have it used as a unit of exchange and value. You don’t need to promise to give people something like gold if it all goes horribly wrong. The US dollar is still (just) the world’s reserve currency. The problem is once you lose this status, you don’t get it back: see sterling.

Crucially, you need faith in that currency: if there is an unlimited amount, then the value may decline. Each unit of that currency may be worth less in terms of the number of bridges it can buy. So, eventually your own domestic population may stop accepting the currency as payment, or you need a friendly central bank and a belief in quantitative easing to maintain a finite supply.

Furthermore, you need few competitors to your currency: if consumers are worried the currency will fall, rather than buy goods and services, they may hoard in gold, property or other financial assets. We could see Apple’s market cap quickly rise to US$3 trillion.

Finally, you need a closed system: if you need to import goods and services and run a trade deficit, you need to hope your currency still holds value internationally. If not, you’d struggle to exchange goods and services for that currency, or a lot more of it will be demanded. Examples of when it hasn’t worked include Zimbabwe, Argentina, the Weimar Republic, Italy from 1945 to 1999 and the UK in the 1970s and 1980s.

Of course, MMT reduces the role of the central bank in setting rate policy. This means handing the keys of the Treasury to the politicians and letting them spend as much as they want. To say the least, this has historically not always led to the most efficient policy making.

Do we think the Fed’s recent actions – Powell reducing rates, preparing to let the economy run hot, petitioning Capitol Hill to increase fiscal spend, hoping to weaken the dollar – are an attempt to adopt MMT? In short, no. It has been a few decades since we studied economics, but fiscal and monetary policy working together wasn’t a new concept even then – indeed, Roosevelt made a reputation from it 90 years ago.

We think if the European Central Bank and Bank of Japan had tried this instead of monetary manipulation masquerading as QE and yield curve control, perhaps we’d have had a decade of decent growth post the Global Financial Crisis instead of the anaemic period we have had.

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Monday, September 21, 2020, 12:20 PM