Yesterday the US Central Bank, the Federal Reserve, announced that they would tolerant higher inflation
For three or four decades now, central banks all around the world have tried to keep inflation below a 2% threshold.
Anything above that threshold, especially significantly above 2%, has usually resulted in a lot of speculation that interest rates would rise.
The Federal Reserve announced yesterday that this policy could be about to shift, with a target of 2.5%-3% more realistic.
“In his latest policy speech, Federal Reserve chairman Jereme Powell made a sweeping monetary policy pronouncement that traced all the way back to the “Great Inflation” of the 1970s and 1980s and tried to explain how there was a persistent labor market recovery while having what were considered lower inflation rates in the aftermath of the Great Recession of 2008-2009.
Since the period of stagflation and rampant price increases that defined much of the 1970s, the average market expectation of 2% in yearly inflation has helped define asset markets from commodities to equity indexes.
It has also been part of the dual mandate of the Federal Reserve to maintain inflation around that equilibrium while also trying to ensure that employment fits close to what economists term “full employment” — the maximum rate of employment that would mark a nearly optimal economy.
The Fed has always played a slightly tricky spot in the middle of these two variables, as they are often at odds.
The Phillips Curve is the most common framework by central banks to explain how in the short-term, there are correlations between unemployment rates and wage rises: namely, that as unemployment decreases, wages are seen to increase, as employers chase after more scarce employees.
The natural correlation that comes from that is that as unemployment decreases and the aggregate level of employment increases, there is more money in the hands of workers and across the economy in the form of wage increases.
As a result, inflation results: there is now, all things equal, more money chasing the same amount of goods and services, and so those goods and services see a general rise in prices.
With the increasing volatility in the markets it becomes important for investors to improve their knowledge of the risks and options in the market through using services like the Money Advice Service which we review on this site.
The Phillips Curve is not a static estimator. Periods of time exist where unemployment has increased while prices have increased — the stagflation of the mid 1970s for example.
Lately, it has also had a muted effect throughout the rise in employment seen after near-zero interest rates were implemented to try to spur a recovery from the 2008-2009 Great Recession.
Analysts projected inflation that failed to come: wage rises also stagnated.
Since 2008-2009, the Federal Reserve now considers inflation, or at least the way inflation is measured, to have undershot its projection and equilibrium.
“Many find it counterintuitive that the Fed would want to push up inflation.” according to Jerome Powell’s latest speech — and he cites why that shouldn’t be the case.
Through it all, the lurking variable seems to be the years of deflation that helped push down consumption levels in Japan and cost it a “lost decade” in economic terms.
Now, Jerome Powell’s statement seems to place an emphasis on boosting broad-based and inclusive employment with the idea that a strong labor market may not cause inflation — and to take the foot off the pedal when it comes to the Fed’s current inflation targeting.
In one of its most conclusive statements, Powell’s speech notes “therefore, following periods when inflation has been running below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
Given that we have been in a period where measured inflation is much lower, this seems to indicate that loose monetary policy with lower rate interest rate targeting will not only be a short-term norm, but also a more protracted result of this longer-term philosophical shift.
While it notes that over-heated economies and inflationary pressures will still be monitored, and the Fed might pivot, this still represents a subtle, but strong shift in philosophical outlook.
For bitcoin and cryptocurrency adherents, this means many things beyond a short-term shift in prices that may or not play out, lost in the noise of extreme volatility.
With the Federal Reserve loosening its inflation requirements and the European Central Bank in negative interest rate territory already, two of the largest central banks in the world are now squarely stepping away from worrying about inflation while cryptocurrencies hawkishly maintain mathematical limits on money supply.
Amid a broader weakening of the US dollar, this may give space for medium-term support for cryptocurrency prices as institutional investors seek hedges to inflation — but the largest thing it does is pit the deflationary forces of Moore’s Law in hardware and other fields, and its increasing ability to potentially displace entire industries of labor against the Fed’s new thesis that through its monetary mechanisms it can accomplish broad-based economic inclusion through policies that generate asset-based inequality that feed into a steady flow of jobs rather than into companies or research that are looking to eliminate them.
After all, labor is the most significant financial cost for most companies — margins are made on the float of automation. Amazon AMZN +0.1%’s cloud compute infrastructure is much more profitable than its business shipping things around the world. The billions being poured into self-driving cars instead of training the workers and entrepreneurs of the future for the industries and demands of the future should give everybody pause.
In many ways, we are talking about very differing visions of economic equilibrium: an economic nation-state based vision of job supply and domestic dollars propped up and ringfenced by governments for its citizens that is distinctly mired in the 20th century, and filled with its wrong incentives and measurements — or an independent, novel perspective that rests on a worldwide set of nodes, much more akin to the networked 21st century.
Jerome Powell’s speech shows cryptocurrency adherents once again that their eternal refrain on the current monetary system being one of fiat is true — and that the thoughts of the few can change quite rapidly and suddenly in ways that a network of many might not”
So what does this mean for your money?
The key takeaways are:
- Don’t expect the lower interest rates we have seen since 2008, and even more so since the start of lockdown, to change anytime soon. We could be about to witness two decades of low interest rates, similar to what Japan has experienced.
- You will probably lose money to inflation in the bank for the next 5 years as a minimum.
- In this low interest rate era, you will need to invest to get a return above inflation. Some people will get it through fixed return instruments, and others will focus on markets, but more money will go into stocks and other assets.
- As companies can borrow more cheaply to expand, this news is probably good for stocks.
- It might be good for real estate as well, but property is more linked to the economy than stocks. In other words, higher unemployment could affect property prices much more than stocks, which are dominated by institutional investors like banks and hedge funds.
- The average difference between long-term bond and stock performance might get bigger, with stocks looking more attractive relative to bonds.
- Other central banks, including in the UK, Japan and the Eurozone, might follow suit.
- The announcement doesn’t automatically mean that the Fed wants more inflation, merely that they will tolerant it for longer, and look towards “average inflation of 2% or a bit more”. In other words, they would be willing to tolerant inflation rates of 3%-5% for a few years, if the average inflation rates are relatively stable.
In essence, in an era where you can’t get yields through bonds and cash, more people will look to market-linked investments.
In a world of automation though, there is no guarantee that what the Federal Reserve is doing will automatically bring unemployment down to February-levels.
The announcements came after US Markets hit more record highs. As Business Insider commented:
US stocks climbed to new records on Friday as economic data surprised to the upside. The S&P 500 and Nasdaq composite reached all-time highs once again as their rallies surged onward.
Consumer spending in the US grew 1.9% in July, the Commerce Department reported on Friday. Economists surveyed by Reuters anticipated growth of 1.5%. The gain follows a 6.2% jump in June and rebukes some fears that the nation’s economic recovery stumbled last month.
The department also said US personal income climbed by 0.4% in July. Economists expected a 0.2% drop.
The Dow erased its 2020 losses, becoming the last of the three major US indexes to turn positive year-to-date. The 30-stock index traded above its December 31, 2019 close on Thursday but ended the session below the threshold. The S&P 500 and Nasdaq composite erased their year-to-date losses months ago on surging tech stocks. The Dow’s smaller exposure to the sector delayed its turning positive for the year.
Investors continued to cheer the Federal Reserve’s shift to a new monetary policy framework. The central bank will now aim for 2% inflation averaged out over time, signaling periods of stronger inflation to balance out today’s lower rate. The shift “was music to the ears of Wall Street bulls,” Craig Erlam, senior market analyst at OANDA Europe, said in a note.
“In theory, by aiming for 2% average inflation, the central bank should hold off a little longer before raising interest rates. Whether they do so to any significant degree is another thing,” Erlam said.
The energy sector led indexes higher through the session. Tech stocks continued to gain, with semiconductor producers including Intel and Nvidia led the group.
Financials outperformed on the Fed’s announcement. Visa and Mastercard jumped the most in the sector.
Workday shares surged after the company beat estimates for second-quarter revenue and earnings. The cloud software firm attributed its success through the pandemic to clients’ spending on solutions for the work-from-home shift.
In other news, Japan’s Shinzo Abe resigned.
As CNBC reported:
The surprise resignation of Japanese Prime Minister Shinzo Abe is unlikely to mark an end to so-called Abenomics stimulus policies, analysts told CNBC on Friday.
Japan’s longest-serving prime minister confirmed reports Friday that he intends to step down due to worsening health. Abe, who served as prime minister for nearly nine years, has battled ulcerative colitis, a form of inflammatory bowel disease, for years but said his health started to deteriorate around the middle of last month.
Offering his apologies to the people of Japan, the 65-year-old Abe said he would resign once the ruling Liberal Democratic Party had formally appointed a new leader.
As investors reacted to early reports of Abe’s departure, Japan’s Nikkei 225 index closed down 1.4%, while the Topix index ended 0.7% lower. The “safe-haven” Japanese yen rose following confirmation of the news, trading at 105.4 against the dollar.
Since 2012, Abe has sought to revive Japan’s lackluster economy through a policy package dubbed Abenomics. He said Friday that the economic policy had succeeded in boosting jobs, and brought an end to 20 years of deflation.
Now, despite Abe’s departure plans, analysts expect a continuation of the country’s reflationary policies.
“The Abenomics framework and (Bank of Japan) monetary policy are likely to remain unchanged despite PM Abe calling it a day,” Peter McCallum, rates strategist at Mizuho International, told CNBC via email on Friday.
“We see little further upside for the Nikkei 225, and would not advise selling Japanese bonds on this news, although weakness in (Japanese government bonds) may persist until the new PM is in place.”
The U.S. dollar slipped 0.6% against a basket of major currencies on the news, weighed down by Abe’s announcement along with the prospect of lower interest rates for longer stateside.
“With a big job still left to do to pull Japan out of its Covid-19 induced recession, this is obviously a difficult time for a change in prime minister. But we would caution against thoughts that this will usher in some even easier policy from the Bank of Japan,” Robert Carnell, ING’s regional head of research for Asia-Pacific, said in a research note.
The Abenomics policy of massive fiscal, monetary support and economic reforms “may not have achieved all of its aims, but it wasn’t an unmitigated failure either, and Japan has made some important progress under his leadership,” Carnell said.
Critics of Abe’s signature economic policies argue the outgoing prime minister failed to make lasting changes to an economy weighed down by low productivity and an aging population.
Abe, who had previously resigned as prime minister in 2007 following a flare-up of his medical condition, has served in the top job since his LDP party registered a landslide election victory in 2012.
His resignation will trigger a leadership race in the LDP, with the winner to be formally elected in parliament. Abe’s successor will serve for the rest of his term, with the country’s next general election set to take place during or before October 2021.
“We do not know who will succeed Mr. Abe in September, so clearly policies are still up in the air,” Martin Schulz, chief economist at Fujitsu Research Institute, told CNBC’s “Street Signs Europe” on Friday.
“But what we know is that the kind of Abenomics we had, with very, very strong quantitative monetary easing, with relaxed fiscal policy — even a big push of fiscal policy — and nitty, gritty small micro reforms will almost (with a) 100% likelihood continue,” he added.
“I don’t think that we will have a big reshuffle or any major structural reforms — that could also be a risk. So, there will be a continuation on that side (but) politically, we don’t know,” Schulz said, reflecting on a time before Abe in which prime ministers in Japan rapidly came and went.
Looking at broader Asian markets, South Korea’s Kospi index and Hong Kong’s Hang Seng index closed slightly higher Friday.
Chinese stocks led gains among the region’s major markets on Friday, with the Shanghai composite up 1.6% while the Shenzhen component gained 2%.
“The economic implications are small,” Tom Learmouth, Japan economist at Capital Economics, said in reaction to Abe’s decision to step down.
He agreed that Abenomics was always “likely to end in name only” when Abe stood aside, given that his successor was expected to come from within the ruling LDP party.
“With public support for his cabinet at record lows, Mr. Abe was unlikely to push for a fourth term as LDP leader past September next year anyway,” Learmouth said in a research note.
“And given the weak and fragmented opposition, his successor as LDP leader and PM should be able to win a comfortable majority at the next general election.”