Sunday, 30 August 2020

 It seems Western central banks are determined to kill capitalism as an efficient machinery for the production of goods and services that preserve national political and industrial power. Here, Bartholomeusz explains how this is happening. Once again, one may point out the wisdom of Professor Pettis's remarks on the importance of 'governance' in the 'measurement' of GDP data.

Why markets barely blinked at Fed's new direction

Late last week the US Federal Reserve Board unveiled its new monetary policy framework, turning its back on nearly 40 years of prioritising a low inflation rate. The financial markets’ reaction was instructive, with the announcement barely causing a ripple.

That may be because the change the Fed chairman, Jerome Powell, announced at the annual Jackson Hole conference was so widely foreshadowed. It might also be because no-one believes it is going to actually change much in the foreseeable future.

Jerome Powell's policy shift barely caused a ripple in financial markets.

Jerome Powell's policy shift barely caused a ripple in financial markets.CREDIT:BLOOMBERG

Since Paul Volker raised the Federal Funds rate (the US equivalent of our cash rate) in 1981 to 20 per cent and killed off what had been rampant inflation in the 1970s, the Fed – and most other major central banks – has prioritised keeping a lid on inflation. That was formalised in 2012 when the Fed adopted a two per cent target/ceiling for the US inflation rate.

In what Powell described as a "subtle" shift in policy, the Fed now says that after periods when the inflation rate has been running persistently below two per cent, it will aim to achieve a rate "moderately" above two per cent for "some time."

In other words, the Fed will allow inflation to overshoot two per cent for some indeterminate period in a form of compensation for periods of low inflation. The two per cent target has become a long term average rather than a ceiling.

In essence, it says that even more debt and leverage is encouraged and that the Fed will provide a rising safety net under risk assets, in the process exacerbating the wealth inequality that has already produced significant social stresses in the US and elsewhere.

Given that the US inflation rate since the global financial crisis has averaged about 1.7 per cent, any concern about the new policy leading to an imminent outbreak of inflation in the US could be regarded as baseless. After all, central bankers have been trying to generate inflation for the past decade – Japan for closer to 30 years - without success.

The post-financial crisis era has, so far, been characterised by low economic growth and low inflation despite the deployment of unconventional and ultra-loose monetary policies and ultra-low interest rates.

That has led to many central banks postulating that there has been structural change in the developed economies - that ageing populations, new capital and people-light technologies that have changed the nature of economic activity and work and the effects of globalisation have generated deflationary pressures throughout the developed world.

If that thesis were correct then low economic growth rates, very low inflation and very low interest rates would be permanent features of the economic landscape and the Fed’s new framework would be irrelevant because the inflation rate would never be consistently high enough to see how the central bank’s "lower for longer" interest rate policy would play out.

The alternative scenario, where inflation did rise above two per cent but the Fed kept rates low would produce an interesting challenge for markets and the Fed.

The Fed can anchor the short end of the US yield curve via the Federal Funds rate but the market sets the rates on longer-dated bonds and would be likely to push them up sharply if it appeared inflation were breaking out, with the threat of market tantrums and meltdowns forcing the Fed to consider more unconventional responses to avoid a financial crisis.

The shift provides additional comfort to investors in equities and other risk assets that the Fed will have their backs long into the future.

The shift provides additional comfort to investors in equities and other risk assets that the Fed will have their backs long into the future.CREDIT:AP

What Powell and his fellow governors have done in revealing their new tolerance for higher inflation is provide additional comfort to investors in equities and other risk assets that the Fed will have their backs long into the future.

The two most meaningful moves in markets on Friday were another rise in the sharemarket and another modest depreciation of the dollar, which is consistent with the implications of that lower-for-longer view on US rates for equities and for foreign investors in the US bond and credit markets.

Whether or not the Fed has the ability to deliver high inflation via low rates – the Fed funds rate is effectively zero and may well end up being negative if the US economy doesn’t rebound strongly from the impact of the pandemic – the signals it is sending to markets are consistent with those that it, and other central banks, have been sending since the financial crisis.

In essence, it says that even more debt and leverage is encouraged and that the Fed will provide a rising safety net under risk assets, in the process exacerbating the wealth inequality that has already produced significant social stresses in the US and elsewhere.

In some respects it is the ultra-loose settings that the central banks have left in place since the crisis that have forced the Fed’s hand.

There is so much debt and leverage in the system – even more now because of the government and household responses to the coronavirus – that central banks couldn’t raise interest rates even if they wanted to without precipitating a dire financial and economic crisis.

The new framework will encourage more debt and keep more zombie companies alive and the capital that could be used more productively trapped within them, contributing to the anaemic levels of economic growth that perpetuated low inflation and low rates.

In effect, analysis of the practical effects of the new policy framework underscores how limited the tools available to central banks really are – and how using the tools that they do have too aggressively tends to generate long-term unintended consequences that increasingly narrow the banks’ room to move.

What would happen if the inflation rate did move significantly above two per cent and remained there for a sustained period? Would the Fed really raise rates decisively to clamp down on inflation, knowing its impact on inflated markets, highly-leveraged companies and on the cost to its government of servicing levels of debt previously only experienced during war times?

By broadly maintaining, for more than a decade, the debt and markets-friendly monetary policy settings they created to respond to the financial crisis the key central banks have locked themselves into policies with no obvious escape routes without risking market mayhem and corporate destruction on a scale much greater than was likely in the aftermath of the financial crisis had the banks allowed the processes of creative destruction to run their course.

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