5-Minute Huddle: The Fed’s Fizzling Power

January 21, 2020

By Justin Pawl, CFA, CAIA

In this week’s blog from Justin Pawl, CFA, CAIA:

  • Last Week Today.  A quick rundown of market-moving news.
  • The Fed is operating in a new era, requiring a new approach to monetary policy.
  • Details of the Phase 1 trade deal.

Last Week Today. The U.S. removed China’s designation as a currency manipulator, a significant concession in advance of the Phase 1 trade deal signed on Wednesday. | Alphabet’s (aka, Google) became the fourth U.S. company with a market capitalization greater than $1 Trillion, joining joined Apple, Microsoft, and Amazon. | The Senate passed the US-Mexico-Canada trade deal (USMCA). | U.S. Retail Sales for December increased as expected by 0.3% month-over-month. Still, October and November were revised lower, reducing the Atlanta Fed’s GDPNow forecast from 2.3% to only 1.8% for the fourth quarter.

Despite mixed economic news, stocks continued higher. Some of the stock appreciation is due to the Fed’s expanding balance sheet, but the first week of earnings also brought good results for the Financial sector as banking/investment behemoths like Goldman Sachs, JP Morgan, and Morgan Stanley soundly beat consensus earnings expectations. When the bell rang on Friday afternoon, the S&P 500 was higher by +2.0%, the Dow Jones +1.8%, and the Nasdaq +2.3% for the week. International stocks rose as well, but are failing to keep pace with domestic equities as the Euro Stoxx Index gained +1.3%, and the MSCI Emerging Markets Index rose only +0.6%. Markets have been rising at a furious pace since the end of 2018, and with retail investors growing increasingly bullish, a pullback would not be surprising, even if the overall outlook for equities in 2020 is generally favorable.

 

The Fed’s Fizzling Power. Last week the Wall Street Journal’s Greg Ip published a relevant article on the waning power of central banks in general and the Fed in particular. It’s worth reading in its entirety to understand the history of the Fed and how today is different, but for those jammed for time, below is a summary.

  • In today’s world, the Federal Reserve’s influence on the business cycle is lower due to the composition of the economy and the new normal in developed countries of low interest rates, low inflation, and low growth.
  • The dramatic growth of the service industries (e.g., professional, education, and health care) has reduced the economic contribution of the most interest-rate sensitive sectors (e.g., durable goods manufacturing and construction). In a new research paper, Larry Summers and Anna Stansbury estimate the response to interest rate cuts has declined by a third, removing a good portion of one of the Fed’s most powerful levers to stimulate the economy.

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Source:  The Wall Street Journal

  • Since WWII, every recession was preceded by the Fed raising rates to control inflation, and every recovery began when the Fed cut interest rates (by an average of five percentage points) to stimulate growth. With the Fed Funds rate below 2% today, there is no room to cut interest rates by that much without diving into negative interest rates. However, the Fed has, for all intents and purposes, stated it would not take rates negative. Negative rates have not helped Europe or Japan, where economic growth remains muted and inflation well below 2%. Thus, the Fed is limited to cutting interest rates to the zero boundary and reinstituting Quantitative Easing. The latter proved excellent at inflating asset prices but has not produced enough economic growth to generate higher interest rates.

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  • Fiscal policy is likely the only game in town. With clear examples of the ineffectiveness of negative rates abroad, many economists have concluded that fiscal policy (i.e., government spending) will be required to pull the economy out of the next recession. History is on the side of economists on this one, as the efforts to fight World War II were primarily financed with debt and helped propel the country out of the Great Depression. Advocates of Modern Monetary Theory (MMT) takes this a step further, suggesting that in the next recession, the Fed should create unlimited money to finance government deficits to stimulate the economy. Like Quantitative Easing and negative interest rates, MMT is uncharted territory, and the long-term impacts are not well understood.

Ip’s article on the increasing irrelevance of the Fed is not fiction, and the Fed is well aware of their waning influence. In fact, the Fed initiated an extensive policy review in 2018 and is expected to share its findings by the middle of this year. The goal of the review is to update its monetary policy to avoid the negative interest rate trap by changing the way the Fed approaches inflation. As we’ve discussed on multiple occasions, the Fed has historically treated the 2% inflation target as a ceiling that should not be exceeded. Modifying the interpretation to 2% as an average target, or setting the target to a higher level, would allow the Fed leniency in letting the economy run “hot” for a period of time. Higher inflation would allow for higher interest rates, giving the Fed more ammunition to combat downturns through traditional monetary policy. The key is to get interest rates higher from where they are now without pushing the economy into a recession. This is one reason we, along with others, asserted that raising interest rates in 2018 was a mistake – let’s hope the Fed still has time to correct it during this economic expansion.

One Down, ? To Go. As expected, President Trump and Vice Premier Liu He signed the U.S./China Phase 1 trade deal on Wednesday. While President Trump suggested Phase 2 negotiations would begin immediately, further progress is unlikely before the Presidential election. So, for now, the new normal is static tariffs and China’s commitment to purchase $200 billion of additional goods and services over the next two years, as follows:

  • Manufactured Goods: $77.7 billion, including aircraft, vehicles, medical instruments, pharmaceutical products, and iron and steel products.
  • Agricultural Products: At least $32.0 billion.
  • Energy Products: $52.4 billion in purchases of liquefied natural gas, crude oil, refined products, and coal.
  • Services: $37.9 billion consisting of charges for intellectual property use, business travel, and tourism, as well as cloud-related services.

While not a panacea for either country, the good news (assuming China holds up their end of the bargain) from the ceasefire is that uncertainty on global trade has been reduced. Greater predictability should give corporate management teams more confidence in their investment plans, improving the prospects for global growth.

Be well,

Justin