You Ain't Seen Nothing Yet
by Zach Marsh on Aug 28, 2020
This week’s financial news of note was that the Federal Reserve announced a dramatic shift in its economic policy making. Rather than targeting a specific inflation rate (2%), the Fed is now adopting a policy called AIT (Average Inflationary Target). The shift, which on the surface may seem minor or semantic in nature, actually can have a profound impact on the long-term forecast for interest rates and as a consequence profoundly affect the prices of all risk assets.
Since the early 1980’s the Fed’s number one goal has been inflation control. When Paul Volcker took over at the Fed in 1979 inflation was 11.35%, and had been elevated for years. Compounding problems was that economic growth had been mired in a multi-year long stagnation. Therefore, Volcker had two problems stimulate growth and bring down inflation. However, it seemed impossible to tackle one without adversely impacting the other. While not politically expedient at the time, Volcker realized that economic growth would never materialize without reigning in inflation. So, in the middle of a stagnant economy, Volcker did the unthinkable, he raised interest rates. From 1979 to June of ’81, the Fed raised the fed funds target rate from 11.2% to 20%. The inflation rate collapsed; by 1983, inflation was 3.5%. After an initial recession in the early 1980’s the economy re-emerged under a low inflationary environment and went on to witness tremendous growth. During his final 5 years as Chair of the Federal Reserve, the economy grew at an average inflation adjusted rate of 5%. By contrast, since 2005, we have never eclipsed a 2.9% real adjusted growth rate.
In the years since Volcker left office, future Fed Chairs would show an equal respect for inflation. Many had seen the damage it had done throughout the 1970’s and the profound negative economic impacts that it had. No one wanted a return to that environment. Fast forward to today, after years of running inflation rates which have struggled to get above 2%, the Fed has now decided to end its history of inflation vigilantism. Going forward, the Fed will no longer raise interest rates in the means of heading off creeping inflation. Rather, the Fed will now let inflation overshoot its old 2% target with the idea that it will either auto-correct/mean revert, or it will tackle the rising inflation after it has arisen. The implications of this change may not just affect prices of goods and services bought and sold in the economy, but asset prices bought and sold in the financial markets.
In the economic sense, low interest rates have the tendency to encourage spending. In the financial markets, low interest rates have the tendency to encourage risk taking. The impact of low rates can be vital when coming out of economic recession and people need encouragement to spend and invest. Knowing that the Federal Reserve will keep rates low has the ability to encourage banks and investors to assume risk by lending and investing money, secure in the understanding the Federal Reserve has “their back”. Perpetual low rates, following a long economic and financial market recovery, has the ability to encourage reckless behavior and novel attempts to seek higher interest rates from new products. In the mid-2000’s this showed up in new mortgage-backed bond and bond proxy investments. These products and their derivatives ultimately brought the economy and the financial system to its knees.
Today, we see dramatic daily price increases in the stock market. We see home prices in many parts of the country rapidly appreciating. The forward price/earnings multiples in much of the stock market are approaching record levels. The market cap/GDP ratio is at record levels. By many measures, valuations are high. Perhaps this is simply a short-term denominator issue, rather than a longer-term numerator problem. I mean, it is possible that both earnings and GDP rebound dramatically and cause a major reset in the valuations. But from where we stand today, asset prices are high and going higher. The Fed may not be able to create a “V” recovery in the economy, but it certainly can in the market.
The old adage is that records are meant to be broken, if the late 90’s Tech Bubble set records for P/E valuations, we have no reason to assume that the level set then is now a ceiling. Fed policy can have the impact of blowing the roof off of those old records. The new policy will lead to more and more Fed capital injections into the market. The impact of Fed policies benefiting the top few and leaving behind the bottom will only be exacerbated. While this new shift looks unremarkable, essentially the Fed is announcing that it will never leave the market, that it will always be involved with trillions of dollars of support. Essentially, Jerome Powell has said, “You ain’t seen nothing yet.”
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