US stock market capitalisation makes up nearly half of the world index. Understanding the actions of the US Federal Reserve (Fed), and how its policy stance impacts markets, is critical for investors worldwide.[i] We have observed a profound change in the behaviour of the Fed post-pandemic.
There is now a focus on unemployment and inclusivity, and under a new more liberal Democratic US government, we expect the Fed to worry about unemployment first, and then inflation second.The market impact is an increase in volatility and a reprise of inflation risk for bonds.
Over the past decade, Fed action has been predominantly focused on prices and inflation. This changed when it dusted off the longer run goal framework (initially drafted in 2012) and made substantive changes on 26 January 2021.[ii]
Phrases such as the following were introduced, showing the Fed is clearly concerned about the low level of rates, and reminding people of its dual mandate around employment and not just inflation:
“Owing in part to the proximity of interest rates to the effective lower bound, the Committee judges that downward risks to employment and inflation have increased. The Committee is prepared to use its full range of tools to achieve its maximum employment and price stability goals.”
In January 2012, the then Fed’s chair, Ben Bernanke made explicit the previously implicit inflation target of 2%, so market participants were able to predict that the Fed would raise interest rates when the 2% line was crossed. The watershed moment under current Fed chair Jerome Powell was the Fed switching from a threshold target to one that is assessed on average. Notably:
“In order to anchor longer-term inflation expectations at this level, the Committee seeks to achieve inflation that averages 2 percent over time, and therefore judges that, following periods when inflation has been running persistently below 2 percent, appropriate monetary policy will likely aim to achieve inflation moderately above 2 percent for some time.”
We believe this is a market game changer. Markets will struggle to adjust to the more nebulous concept of an average inflation target, especially with an unclear time period for the average calculation.[iii] The US economy is thus going to run hotter than in the past.
The huge impact on the labour market brought about by the global pandemic and lockdowns has put employment and getting the US ‘back to work’ at centre stage. Janet Yellen, ex-Fed chair and now the more leftist Democratic Party’s Treasury Secretary has voiced her support of pro-employment policies due to her past academic interest in labour market hysteresis (the persistence of economic effects). Periods of low unemployment can create other persistent positive effects such as raising skills levels, bringing previously side-lined people into the labour force, and raising living standards.
In a post-COVID world, stubbornly high unemployment grimly threatens the reverse – persistent negative effects. Despite the eye-watering levels of stimulus and fiscal support in the US, unemployment has not returned to the 3.9% level of December 2019. Although it has fallen from the shutdown peak of 14.8% to 6.2% in March 2021, Powell warns that the actual unemployment rate is misestimated and could be “closer to 10%”. With the current labour market distortions in play, policymakers clearly remain concerned about these elevated levels.
However, the Fed has taken this one step further and introduced into the Fed goal framework:
“The maximum level of employment is a broad-based and inclusive goal”.
These are laudable ideals, but risk the Fed getting drawn into the political goals of the administration. Fiscal policy is undoubtedly a better tool to deal with this than monetary policy. Nevertheless, Jerome Powell has been very vocal on the need to tackle wider social imbalances. [iv]
Powell’s speeches have covered improving wage growth in the lower quartile of workers, tackling inequality by monitoring the higher levels of unemployment amongst minorities like Black African-Americans, and observing through labour participation rates how less educated (non-college) workers are kept within the workforce.
For example, in Figure 1: Tackling inequality in unemployment the levels of African American and Hispanic unemployment are much higher than the 6% rate of total US employment.
Figure 1: Tackling inequality in unemployment
The Fed’s approach to steer the US economy has clearly become more complex. The policymaker shift of focus from Wall Street (investors and the markets) to Main Street (the man in the street) over the next decade is a theme that we signalled at the start of 2020.
Impact on markets
This as yet untested Fed reaction function comes at a difficult juncture for markets. Interest rates are close to their lowest level in many markets globally as governments are trying to kickstart fragile economies. Rates close to zero means traditional behaviour may not work as intended. So, old rules of thumb are out of the window. This is new territory for policy makers and investors alike.
Investors are also unclear about the Fed’s reference points. Our premise is that increased US market volatility will be a consequence of the Fed’s policy and behaviour change. Must total unemployment return to the level in December 2019 of, say, 3.6%, or is a higher rate more likely, given the tremendous structural change created by work from home under COVID-19? How much must minority unemployment improve? In the past, these rates have always been higher than the total unemployment rate. Is the Fed looking to just get back to the past differentials, or completely close the gap? Or target somewhere in-between? And when does inflation and not employment retake the focus? None of this is known.
Foreseeably, inflation will drift higher than expected by the market before the Fed starts to react. High inflation can rapidly get out of control, so should investors be pricing in potential policy mistakes?
This is a great concern for bond investors, who are paid set nominal amounts in the future and are exposed to unanticipated inflation. If we are moving into untested, yet higher, inflation waters, then it seems rational that bond rates must rise (and bond prices tumble) as a new inflation risk gets ‘priced’ into markets.
This continues to underline the weakness of a 60/40 ‘passive’ bond
holding to control risk in a balanced portfolio. More comprehensive
multi-strategy approaches, that can draw on other asset classes and strategies,
aim to provide more diversification and risk mitigation. The Fed’s new
framework puts investors into new waters, and all we can be sure of is some rapids
[i] The Federal Reserve is the US Central Bank governing the country’s monetary policy and interest rates.
[ii] Fed’s ‘Statement on Longer-Run Goals and Monetary Policy Strategy’ can be found at https://www.federalreserve.gov/monetarypolicy/files/fomc_longerrungoals.pdf. One can see the changes marked up here: https://www.federalreserve.gov/monetarypolicy/guide-to-changes-in-statement-on-longer-run-goals-monetary-policy-strategy.htm
[iii] Jerome Powell explicitly said in his August 2020 Jackson Hole speech “In seeking to achieve inflation that averages 2 percent over time, we are not tying ourselves to a particular mathematical formula that defines the average.” (https://www.federalreserve.gov/newsevents/speech/powell20200827a.htm)
[iv] Refer to Bloomberg news. For example, 7 March 2021, Powell’s dashboard how far US economy has to go on jobs