The Federal Reserve this week managed to pull off the greatest trick in the central banking handbook: being boring.
After its latest monetary policy-setting meeting, it confirmed plans to start trimming its bond purchases by $15bn each month, putting it on track to remove that leg of its stimulus completely by the middle of next year.
These plans came as little surprise in the context of punchy inflation readings that are proving much stickier than even the sharpest inflation pointy-heads had predicted.
The central bank’s move had also been well flagged in advance, removing any undue shock factor; the Fed typically likes to deliver dovish surprises, dollops of largesse that support the economy and, by extension, give risky assets a boost. By contrast, it is not a fan of unanticipated hawkish lurches, especially in light of the “taper tantrum” in markets, unleashed when it declared an intention to pull back monetary support in 2013.
But in his press conference, Fed chair Jay Powell poured on yet more soothing balm, flicking away talk of moving smoothly on to interest rate rises, saying it was “appropriate to be patient” and suggesting that asset purchases could still crank back up if the circumstances demanded — a “tidy taper” as HSBC put it.
The result was to make Powell and the Fed neither hawkish nor dovish but something in between. “Dowkish”, to be precise, in the made-up word of Rabobank economist Michael Every.
“The irony is that being a dowk, and saying tapering is about ‘risk management’ rather than taking away the punch bowl from an aggressive drunk, means the Fed produced its best possible outcome — drunker markets — and yet its worst possible outcome — drunker markets,” Every wrote. It was a “partial removal of liquor-pouring with no true injection of responsibility”, he added.
Evidence of tipsiness is everywhere, and as every barmaid knows (I’ve done my time pulling pints, albeit badly), ejecting the inebriated from the premises late at night is a fine balancing act.
For now, the after-hours lock-in is still in full swing. On the same day as the Fed announced its shift in stance, the S&P 500 index of blue-chip US stocks closed at yet another record high, its 61st of the year so far, according to Charlie Bilello at Compound Capital Advisors. Just 17 more to go to break the record set in 1995.
We don’t hear Joe Biden shout about it (unlike you-know-who) but the year since his election as US president has proven to be the best first year for any president since 1932, according to Charles Schwab.
For the Fed, the reluctance to raise rates or otherwise tighten too quickly is understandable. Supposedly one-off factors keep springing up to lift inflation, from the European wind shortage that helped raise gas prices to the soaring cost of fertiliser that points to higher food prices next year.
But as Gareth Colesmith, head of global rates at Insight Investment, puts it, the benefits of pumping up benchmark rates to tackle that are hard to discern. “Can they fix it? No not really,” he said. “They could take away the stimulus, they could raise rates, but they would need to raise rates more than inflation. If you tighten too much too quickly, you will crash things.”
In addition, once supply chain bottlenecks did ease up next year, transitory bouts of inflation could easily flip into transitory disinflation or even deflation, he added. Some central banks look like they are dragging their heels on inflation right now, but the risk of clamping down too hard is real.
All this leaves stock markets in the sweet spot they have occupied for most of the past year-and-a-half. But it sets the scene for a monstrous hangover further down the line.
This was “a real dilemma for the Fed”, said Robin Brooks, chief economist at the Institute of International Finance. “The basic rationale for tapering is the same as in 2013: bring longer-term Treasury yields up to tighten financial conditions and prevent overheating. So it’s worrying this just isn’t happening, raising the risk of a more violent correction later on.”
Alan Ruskin, an analyst at Deutsche Bank, also this week noted that “asset cycle booms allied to monetary excesses and other policy errors usually end up in tears”. But the “comeuppance” was likely to be delayed, he said, partly because companies were loaded up with super-cheap debt and could withstand interest rate rises better than in previous cycles, and partly because households were still flush with excess savings. “The short-term risk appetite prognosis is probably better than expected,” he wrote.
“The Fed’s actions in 2020, as necessary as they felt . . . have taught another generation of equity investors that the Fed will be there to save their back, and every dip must be bought,” he added. “Even as inflation takes off, there is plenty of chatter that equities are the best asset class to initially take shelter in. It will need either a much softer economy, or better fixed income alternatives (higher yields), to break the positive equity herd mentality.”