Fed repression could turn to Fed regret

Federal Reserve

At its latest policy meeting the US Federal Reserve (Fed) signalled that interest rates would be close to zero for the next three years as it aimed to hit its new objective of a 2% average inflation target and maximum employment.

The central bank’s economic projections show that it intends to run the economy “hot” for a period. The goal? To drive inflation up, whilst enjoying the benefits of stronger growth and lower unemployment.

There has been almost universal agreement that the Fed’s new policy framework is a step in the right direction. Its previous policy had led to the 2% inflation target being constantly undershot.

Increasing the focus on employment provides an opportunity to spread the gains of growth more widely and address increased inequality in the economy. Before Covid-19 struck, Fed chair Powell had noted approvingly that wages for lower income workers had picked up as unemployment hit 50-year lows.

Repression to spark renewed hunt for yield

However, the new policy also amounts to a significant increase in financial repression.

Three years of zero interest rates await. This will significantly challenge investors, who will now struggle even more to generate income from their savings.

An extended period of zero interest rates is not unprecedented. In the wake of the global financial crisis, the Fed kept its policy rate close to zero for nearly six years between December 2008 and November 2015.

This drove a search for yield amongst investors, who poured funds into bonds and equities, particularly those which could promise consistent dividends. Markets performed strongly thanks to the economic recovery and a wave of liquidity.

Today, the search for yield is likely to be at least as intense if not more so, as Treasury bond yields are significantly lower. For example, 10 year Treasury yields averaged 2.4% between 2009 and 2015. Today they stand at just 0.7%.

View Full Article – published by Schroders on 16th October 2020