The principle aims of a Central Bank are price stability and sustainable economic growth. To do this they are, traditionally, given control of interest rates and the supply of money. Since the Great Financial Crisis, they have also been allowed to influence interest rates through market purchases of debt securities in particular Government bonds, through QE.
Implementation of truly forward-looking policy seems to have taken a back seat.
Implementation of truly forward-looking policy seems to have taken a back seat. In an environment today which feels increasingly unaccustomed, where the repercussions of political events are proving hard to judge, reactive policy changes seem to be the preferred – and perhaps safer option – to an attempt at proactive, forward-looking policy.
It seems better to be a late Central Bank than a wrong Central bank.
Moving towards policy normalisation?
The FED met the market’s expectations with their 16th March announcement of a 25bp rate increase and a new target interest rate range to 0.75-1%. The announcement came alongside confirmation there would likely be two more 25bp moves this year. Perhaps we’re still one surprise hike away from having a ‘hawkish FED’ but either way, with US unemployment already so low and inflation roughly at its target level, there is no doubt that we are still a distance behind what would be considered policy normalisation.
Tuesday’s announcement that UK inflation has hit 2.3%, overshooting the Bank of England’s 2% target, is another example of the same policy trade-off. High inflation is deemed an acceptable outcome when the alternative is tightening policy too quickly and potentially hampering a fragile economy’s recovery. Financial stability trumps price stability, for the time being.
This reluctance to look too far ahead is further emphasised when we consider the prolonged QE programmes in the US and elsewhere.
Eurozone GDP growth is strong, unemployment is falling fast and inflation is at a 4 year high yet interest rates are negative and the ECB continues to buy in bonds. While the FED did stop their QE programme a while back, the correlation between their balance sheet and the returns of the S&P 500 highlight a key anxiety.
What would be the impact of a hawkish unwinding of these purchases, bringing the Central Bank’s reserves back to a historically normal level? Can they risk the asset bubble bursting just now?
Board of Governors of the Federal Reserve System (US), All Federal Reserve Banks: Total Assets [WALCL], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/WALCL, March 21, 2017. S&P Dow Jones Indices LLC, S&P 500© [SP500], retrieved from FRED, Federal Reserve Bank of St. Louis; https://fred.stlouisfed.org/series/SP500, March 21, 2017.
It is this fear that keeps Central Banks ‘behind the curve’. Like an injured animal being released back into the wild, there is always the risk of not being quite ready. But the longer you wait the harder it is to survive the transition.
Central Banks are playing a wait-and-see game at present.
What does this mean for investment managers?
Regardless of whether this is the best course of action or not, right now, it’s through proactive policy and anticipation that stability is brought to an economy. Given the time it takes for the effects of policy changes to be felt, reactive changes can result in extenuating the peaks and troughs of cycles rather than smoothing them out.
It is in these gaps that diligent risk management when investing really comes to the forefront.
Fund managers who focus on downside protection and aim for positive risk-adjusted returns across the full business cycle can add a layer of protection for the investor, between their portfolio and the impacts of the wider world.
