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Summary
As the UK prepared to head to the beach for August bank holiday, the world’s central bankers descended on Jackson Hole in Wyoming for the US Federal Reserve’s annual symposium. The title this year was sure to be a Thiller: “Financial Innovation: Implications for Payments and Policy”, but the thing we were all waiting for was Fed Chair, Kevin Warsh, to give us the ABC of his thinking on interest rates.
To date, the new Fed Chair has been far from Black or White regarding the future direction of US monetary policy. This is by design. Warsh believes markets have become over reliant on signalling from the Fed.
I have some sympathy with this view, but an inconvenient consequence of providing less guidance is that Treasury yields will be higher than they might otherwise be: it is Human Nature for investors to demand more yield to compensate for greater uncertainty. Of course, higher yields mean bond prices go down, so this is bad if you already hold bonds, but makes them more attractive for new investors.
Wanna Be Startin’ Somethin’
The primary tool that central banks use to influence economic conditions is short-term interest rates. They lower them to stimulate growth by encouraging more spending and investment, they raise them to slow growth by discouraging spending and investment. There is no obvious limit as to how high interest rates can go, but it used to be thought that zero was the floor.
In the early 2000s following the Dot Com market crash and ensuing recession, the Fed reduced interest rates sharply but inflation kept declining through 2002-3. This was partly down to expectations that interest rates would soon increase, so even though current interest rates were down at 1%, medium term bond yields were high in comparison. This kept demand constrained, stopping the economy from re-accelerating and generating inflation.
By signalling their intention to keep interest rates low, the Fed was able to suppress longer dated bond yields, adding extra stimulus to the economy to get inflation back up again.
Don’t Stop ‘Til You Get Enough
The trouble is, once you’ve started it is difficult to stop. During the Global Financial Crisis, the use of forward guidance became more habitual and now investors almost always expect a steer on the likely next step of monetary policy. This has created all sorts of unintended consequences.
One thing you know about a forecast is that it will probably be wrong, but investors tend to treat these forecasts as gospel. If the facts change and forward guidance needs to be rowed back on, investors feel like the central back has done the Dirty Diana on them. This harms policy makers’ credibility.
Smooth Criminal
President Trump has been vocal about his desire for lower interest rates. He’s a property guy, so lower rates are never Bad. Many assumed Warsh got the Fed Chair job based on a promise to cut interest rates, but interest rate expectations have continued to move higher in the run up to Warsh’s confirmation and during the first 3 months of his tenure. So, has the Man In The Mirror changed his ways? Or was this a misinterpretation all along?
While Warsh quipped that his speech should not be mistaken for forward guidance, it leaned a little hawkish relative to expectations. He focused in on inflation remaining above target, and that restoring price stability is his primary objective. This doesn’t sound like someone who is about to bend to Trump’s wishes and cut interest rates.
However, he also spoke about productivity gains from AI, suggesting that this could help reduce inflation. This is where economic thinking can become muddled. Lower inflation might suggest that interest rates could be reduced, but in the longer term, higher productivity means higher growth rates and probably higher interest rates.
It remains a hard one to call, but bond yields moved higher in the wake of the speech suggesting renewed confidence that hikes are coming. The market is priced for a couple of interest rate increases over the next 18 months, and this seems like a sensible guess. Either way, the message is coming through loud and clear: if you’re looking for explicit clues as to the future path of interest rates then you can Beat It.
CJ Cowan
Portfolio ManagerCJ is a portfolio manager of the Quilter Investors Cirilium and Monthly Income Portfolios. CJ joined Quilter Investors in August 2018 from Aberdeen Standard Investments where he worked in the global macro team, managing global government bond and global aggregate portfolios.
CJ is a CFA charterholder and has also completed the Chartered Alternative Investment Analyst qualification. CJ has a degree in economics from the University of Bristol and an MPhil in Economic and Social History from Brasenose College, University of Oxford.
