Circumstances constrain Fed’s freedom

By Atul Bhatia, CFA

The U.S. Federal Reserve is an outlier among major developed central banks in that it has a so-called dual mandate. While most central banks focus on keeping inflation near a given target, the Fed is charged with maximising employment consistent with stable prices. A third task, keeping long-term interest rates moderate, usually goes unmentioned but remains on the books.

To achieve its mandate, the Fed is often viewed as having complete freedom of action in setting monetary policy. Technocrats, sitting on high, who can pull the levers as they see fit.

We don’t know if that’s ever been a fair description of the central bank’s effective latitude, but we think it falls far short of describing today’s reality. In particular, we would call out the macroeconomic importance of asset prices and the harsh realities of the federal government’s budget deficit in limiting the Fed’s degrees of freedom in setting policy.

It’s all about the secondary effects

The Fed has long disclaimed any target price for stocks, saying instead that efficient markets rule the day. While we appreciate its respect for academic theory, we think we’re beyond the point where it’s credible to argue that asset prices are not a factor in monetary policy setting.

In a sense, the question is largely semantic. The Fed may not be targeting a given equity level, but it has to be thinking about how stock prices are filtering into GDP growth and labour demand.

The key link is household consumption, which accounts for roughly 70 percent of U.S. GDP. Since production demands labour, the Fed – with its mandate to maximise employment – keeps a weather eye on spending trends.

Once upon a time, employment and consumption tended to move in lockstep. Growth demanded workers, and labour shortages led to higher wages, which in turn led to robust household spending. The cycle continued until it created inflation, and the Fed stepped in to take the punchbowl away. While asset prices tended to rise during these periods of strong growth, we argue that the causality largely flowed from strong labour demand to consumption to GDP growth to equity prices. The fundamentals were the story, and the equity index was the consequence.

The situation today, we would argue, is distinct.

While consumption still drives the U.S. economy, the driver of gains is increasingly coming from the top 10 percent of households by income, a sector that now accounts for a third of all economic activity in the U.S. These households tend to adjust spending in response to changes in their net worth, which is largely a result of fluctuations in stock prices.

A significant fall in stock prices, therefore, is likely to have real-world impacts on consumption, which in turn will hit GDP growth and eventually labour demand. Even if the Fed wants to buy into efficient markets, it has to consider how falling stocks filter through the economy.

Rate hikes meet deficits

Fiscal policy, we believe, is another under-acknowledged factor in monetary policy making.

The U.S. is growing its debt at a pace that is well above the norm for an economic expansion – nearly six percent of GDP per year. In addition, the U.S. government has been ratcheting up its reliance on short-term funding versus longer maturities – more than 20 percent of federal debt matures in less than one year. And all of this comes against the backdrop of a total U.S. debt burden that is larger than the U.S. economy.

We see two reasons the Fed has to be cognizant of fiscal policy when thinking about rates:

1. Shorter maturity bonds are particularly sensitive to Fed action, so tightening policy implies a higher probability that the U.S. government has to dedicate more resources to paying interest and less to tax cuts and spending priorities. This pressures growth downward as it moves funds away from high-powered government programs to T-bill investors – not exactly a freewheeling group of spenders, in our experience.
2. The U.S. debt burden is large, and inflation helps reduce the real cost of paying back those obligations.

While setting rates to facilitate government deficits sounds menacing, it’s not at all clear to us that tolerating higher inflation to help slow the pain of fiscal normalisation is the wrong move under the current mandate. How much weight that should have in Fed deliberations, we believe, is an open question. That the central bank has to at least consider it under the current mandate is not, in our view.

No free lunch

Wealth effects and government debt are nothing new, but we would argue that the scale of these factors is considerably higher today than it was in the past.

Take wealth effects. Historically, home prices were the key catalyst linking asset prices and consumption – this was a broad-based fillip to demand, but it relied on cash-out mortgage refinancing. After the post-COVID wave of low-rate mortgages, this channel is effectively cut off. As a result, the absolute and relative importance of equity prices on consumption has risen.

In a similar vein, while the U.S. debt has been growing steadily for years, both the pace of accumulation and the current magnitude make it a more pressing concern, in our view.

Incorporating these non-traditional factors into rate setting doesn’t come without risk, of course.

To begin, it’s likely only delaying the inevitable reckoning in U.S. finances and will arguably end up raising the total costs of the adjustment when the bill comes due.

Second, the central bank is essentially creating a one-way ratchet on asset price moves. When asset prices go up, the Fed dismisses those criticisms based on faith in the efficient markets’ hypothesis and the difficulty of identifying overvaluation in real time.

When a bubble bursts or stocks falter, however, the Fed is quick to rush in to cushion the selloff. If markets are efficient on the way up, why are they inefficient on the way down? And if we instead rely on the secondary impact of falling asset prices to justify rate cuts, why do we fail to consider the whole range of secondary impacts of rising asset prices?

Talking elephants

In all fairness, it is both difficult and arguably dangerous for central bankers to be sitting in judgement on where the “correct” price of future cash flows should lie. Moreover, we are not suggesting that today’s equity market is in any way stretched to the point of the pre-Global Financial Crisis period or the internet runup of the late 1990s. In a similar vein, the Fed cannot force Congress and the administration to act like adults.

But we are suggesting that investors need to think about the constraints on the Fed’s decision making when evaluating likely future policy moves. Rather than emphasising the subtleties of second derivatives on super-core inflation, it is worth considering that the central bank may find its hands tied by the dual constraints of wealth effect spending and an ever-rising U.S. debt.

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