By: Old Mutual Wealth Investment Strategists Izak Odendaal and Dave Mohr
Former US Federal Reserve Chair William McChesney Martin famously said that the job of the central bank is to take away the punchbowl just as the party gets going. In other words, to act pre-emptively by hiking interest rates before the economy overheats and inflation rises. Richard Nixon, then vice-president, blamed Martin’s tight money stance for his defeat in the 1960 presidential election. In 1970, after his second attempt at becoming president succeeded, he fired Martin.
The Fed recently abandoned this old punchbowl theory of monetary policy. After a major review, it effectively decided late last year that the punchbowl needs to remain in place so that the party can get going properly, and the more subdued the party has been, the longer the punchbowl needs to be there. It will only be taken away when guests really start misbehaving.
Running the economy hot
In other words, the Fed’s plan is to let the economy rev up so that those who want to work can find jobs, and so that the average inflation rate over an unspecified number of years can rise to its 2% target. Since inflation has been below 2% for so long, it would need to be above 2% for some time for the target to be reached on average. As far as the labour market is concerned, the experience immediately prior to the pandemic showed that the more jobs become available, the more discouraged work seekers re-enter the labour force. Low unemployment did not lead to higher inflation, as the so-called Philips Curve suggested it would.
Why does this matter? It matters because the market is testing the Fed’s commitment to the new punchbowl theory. Bond yields in the US have been rising as prospects for economic growth improve. The market is betting that the Fed will start tightening policy sooner than it says (first by ending quantitative easing and then by hiking interest rates). Basically, it is betting that the Fed will be spooked by the first sign of rowdiness at the party and start whisking away the drinks.
Chart 1: US 10-year government bond yield and policy interest rate, %
Source: Refinitiv Datastream
That is not how the Fed sees it. At its monthly policy meeting last week, it did not change its stance in response to higher yields. Instead, it reiterated that the Fed would need to see clear evidence of “substantial further progress” in the labour market and sustainable increases in inflation before even talking about slowing its bond purchase programme and eventually raising rates.
“We will continue to provide the economy with the support that it needs for as long as it takes,” noted current Chair Jerome Powell.
The famous ‘dot plot’ still shows no hikes on the horizon even though the Fed’s own forecasts for economic growth are 6.5% this year, the fastest expansion since the early 1980s. It marked up its growth projection following the passage of the American Rescue Plan Act, President Biden’s $1.9 trillion fiscal injection which included $1400 cheques mailed to many households.
The Fed projects inflation to rise above 2% this year, but then fall back in subsequent years. In contrast, many market participants expect sustained higher inflation, and hence expect the Fed to be making moves towards the punchbowl sooner.
Chart 2: US policy interest rate and inflation, %
Source: Refinitiv Datastream
There are certainly price pressures in global value chains at the moment as there are all sorts of bottlenecks, shortages and disruptions. There is a global lack of microchips, for instance, which impacts a wide range of products including vehicles.
The blocking of the Suez Canal by one of the world’s largest cargo ships will add to these pressures, causing considerable delays. Some other ships have been rerouted around the Cape. As with most other bottlenecks, this will be temporary. All involved parties have every incentive to address the problem as quickly as possible.
The other source of inflation, also temporary, is simply the fact that prices fell sharply a year ago. Take the oil price. It hit a low of $16 per barrel in mid-April last year. On Friday, it was $61, 132% higher on a year-on-year basis. However, if the oil price stays at $61 for the next 12 months, oil inflation will fall to zero. This will add to headline inflation across the world. Fuel comprises roughly 5% of the South African inflation basket and 3% in America. In other words, the impact is likely to be limited and transitory unless oil prices keep rising and firms keep passing those costs on to consumers, and consumers in turn bargain for higher wages to compensate for the increased cost of living, which again forces firms to increase selling prices.
This is the dynamic that led to runaway inflation in the 1970s, but it seems very unlikely now. Unemployment rates are still elevated and consumer demand constrained. No one has much bargaining power in a globalised economy. The oil price will always be volatile, but sustained increases can only take place with ever-tighter supply cutbacks, since demand may have permanently peaked, as the International Energy Agency recently predicted, due to higher fuel efficiency of newer cars and the increased sales of electric vehicles.
At any rate, oil acts as a tax. Higher fuel prices often reduce demand for other items, putting downward pressure on their prices. The same is true of higher food prices.
In other words, it doesn’t look like the Fed will blink, and the market might therefore be too aggressive in its pricing of higher interest rates.
The market’s punching bags
Bond yields are still low in absolute terms, but it is the speed with which they’ve moved up that has caused problems both for equity markets (which have been volatile the past few weeks) and for emerging markets, the traditional punching bags of world markets. Further sharp increases would be problematic, but nothing ever moves up in a straight line. The increase in US yields since the start of the year is of a similar magnitude to previous spurts higher, suggesting that by historical standards at least, most of the adjustment is behind us.
What would really hurt emerging markets would be a one-two punch of higher bond yields and a stronger dollar. American growth is expected to surpass that of other advanced economies. Europe in particular has delivered a much smaller fiscal stimulus package, spread out over a longer period. It has also suffered a worse coronavirus impact and has been slower to get its vaccination campaign going. While all the ‘money printing’ in the US should be negative for the dollar, the higher associated growth rates and bond yields is positive. The dollar started weakening against the euro in May last year as investor risk appetite increased. That has been reversing since the start of the year.
Brazil and Russia joined Turkey last week in becoming the first major economies to see their central banks hike interest rates since the pandemic struck. In the case of Turkey, it cost the central bank head his job. Turkish President Erdogan is now on his third central bank chief in two years, someone he hopes will be more sympathetic to his low-rates-at-all-cost view of the world. Needless to say, the market doesn’t see it that way, and punch-drunk Turkish bonds, equities and the currency took further heavy blows. We may have our shortcomings, but our credible and independent central bank is not one of them.
As for Brazil and Russia, both economies do face accelerating inflation – most emerging markets are more inflation-prone than the more flexible and services-heavy developed economies – and interest rates are coming off record lows. The increase in global bond yields will have weighed on policymakers’ minds.
The South African Reserve Bank is not there yet. Its Monetary Policy Committee left the repo rate unchanged in a unanimous decision. In the previous two meetings, two of the five MPC members voted for a cut. Their unanimity this time suggests further cuts are off the table for now.
Actual inflation remains quite low. Consumer inflation dipped to 2.9% year-on-year in February as food price inflation cooled and medical insurance, a big item in the consumer price index, increased 4.7% from a year ago, a much slower pace than usual. Core inflation, which excludes volatile food and fuel prices, fell to a record low of 2.6%.
Chart 3: SA repo rate and consumer inflation %
Source: Refinitiv Datastream
While the Reserve Bank raised its 2021 inflation forecast somewhat, due largely to higher assumed fuel and electricity prices, inflation is expected to remain comfortably within the target range. It is forecast to average 4.3% this year, 4.4% next year and 4.5% in 2023. Inflation expectations also remain well anchored. The Bureau for Economic Research’s first quarter survey of households, businesses, unions and analysts show inflation is expected to average 4.5% over the next five years, slightly lower than the previous quarter.
Given that the Reserve Bank targets inflation of 4.5% (the midpoint between 3% and 6%), the repo rate can remain at 3.5% for some time. However, our central bank very much still subscribes to the old punchbowl theory and can be expected to raise rates if it anticipates that inflation will increase.
As with other emerging market central banks, it doesn’t have the luxury of ignoring a tightening of global financial conditions. If there is an episode of large-scale capital flight, it might be forced to raise interest rates as it did in 2013 and 2014. So far, the rand has been fairly stable, and as the MPC statement noted, the impact of exchange rate movements on inflation has declined over time.
For the time being, low interest rates support the local economy. Also noting the strong global growth environment, the Reserve Bank raised South Africa’s growth forecast for 2021 to 3.8% from 3.6% previously, while the outlooks for 2022 and 2023 remain unchanged at 2.4% and 2.5% respectively. If realised, these would be very impressive numbers compared to recent history.
So what is the punchline of this story from an investment point of view? Though the Reserve Bank’s forecast model suggests two interest rate hikes during the course of the year, this seems unlikely given the muted inflation outlook. South African cash is likely to deliver negative real returns this year. Bonds have taken a knock over the past month as yields have followed global yields higher. These yields of 9% to 10% remain attractive compared to expected inflation, but investors will clearly have to stomach some volatility.
As for equities, some sectors and companies of the global market are at risk from higher yields as their valuations will have to adjust lower. But at the same time, strong global economic growth means companies can grow earnings rapidly. Together with policymakers’ ample support, this means it is still a very favourable backdrop for equities once investor expectations of yields settle.