The last time the US Federal Reserve made hawkish noises about inflation and economic prospects it quickly changed its mind, sparking debate about what motivated the dramatic reversal.
Was it then-president Donald Trump’s outbursts, or markets that had got addicted to a diet of ultra-loose monetary policy?
Before that December 2018 hike in the federal funds rate, which came with a hint of two more to come during the course of 2019, the erratic Trump had more than once made his annoyance with Fed chair Jerome Powell well known. He even went as far as to ask, in a tweet in which he misspelt Powell’s name, if he was a bigger enemy of the US than Chinese President Xi Jinping.
The final verdict was probably that in the end Trump was correct — about rates, not Powell’s alleged disloyalty — and the market seemed to agree that policymakers had misread the economic outlook and risked pushing the economy into recession with premature and too-aggressive tightening.
Stock markets responded appropriately and pushed the Dow Jones to its worst decline since 1931. This was before Covid-19 and the associated lockdowns would make “the worst since the Great Depression” a compulsory addition to any article about the economy or financial markets.
The Fed relented, and by January 2019 had changed its tune. Instead of hiking interest rates further, it lowered its main rate three times, setting off a race for yield and risk-taking that sent US stocks to their biggest annual gains in about six years, with the S&P 500 rising 29%.
The tantrum, whether by Trump or traders, worked. Could history repeat itself? This time things might well be different, as the Fed’s stance seems to be more in tune with how investors see things. There was a sell-off, with US stocks posting their biggest drop in four months and bond yields rising, but nothing like late 2018.
Perhaps markets see a rate increase in 2023 as too far into the future. With the Fed expecting the economy to grow by 7% in 2021 and 3.3% the following year, would raising rates by 25 basis points twice in two years’ time really make a difference?
That’s if they come. Like SA Reserve Bank governor Lesetja Kganyago, who goes to great lengths to explain that the Quarterly Projection Model (QPM) doesn’t dictate to policymakers, Powell stressed that the Fed’s dot plot is also not “a great forecaster of future rate moves” and should be taken with “a big grain of salt”.
During the course of the Covid-19 lockdown-induced slowdown, the Fed also demonstrated that perhaps the middle of a crisis is not a great time to make policy changes that may have implications for SA. Some analysts have questioned whether the Bank should use a period of benign inflation to suggest a change to its target, which in any case is set by the government.
In 2020, the Fed announced a big shift that turned on its head the idea that central banks don’t use the rear-view mirror when setting policy. So rather than looking at what inflation was last month, they look ahead to where they expect it to be in future and act in a pre-emptive manner.
With the economy still constrained by lockdowns and inflation nonexistent, the Fed announced that in future it would target average inflation, allowing the annual rate of change in prices to run “moderately” above its target “for some time”. Now that inflation is back, running at 5% in May compared to its 2% target, investors will be left wondering what policymakers regard as moderate.
And now they will have to take into account the risk that it may wait too long and allow inflation expectations to be entrenched at a higher level. The goal of attaining full employment before policy tightening is also vague. The danger for investors is that the Fed ends up being behind the curve and is forced into unplanned and sharper rate increases later, destabilising markets.
In SA, as inflation collapsed in 2020 to below the lower end of the target range, there was some debate about whether the Bank could also use the crisis to entrench lower inflation expectations by changing its goal. Some economists have argued that the 3%-6% target was inappropriate and that SA should aim for a rate closer to that of its trading partners.
While the Bank has had no discussions with the Treasury about changing the target, and that is not on the agenda, it could also achieve its goal by changing its guidance on where it wants the rate to be anchored. In recent years it has been consistent on wanting it anchored at the midpoint, so much so that for economists and other observers 4.5% has become the de facto target, with inflation expectations reflecting the credibility of its stance.
So far this has been helpful for SA and means we can still be relaxed about the outlook for rates, irrespective of what happens elsewhere. The Bank expects inflation to average 4.4% and 4.5% in 2022 and 2023 respectively, and unless that changes, SA can reasonably expect the economy to remain supported by historically low interest rates.
It might have been a good idea to change the guidance in 2020, if one believed the pace of price changes during a pandemic would be a semi-permanent feature. It would have been a mistake though. At a time when price increases are accelerating everywhere, such an adjustment would imply higher interest rates and more political noise around the Bank’s role.
Some crises may be best left to go to waste.