This summer, it seems that some investors may have forgotten the long-standing axiom, “Don’t fight the Fed.”
The stock market is a leading indicator since investors buy and sell securities hoping to profit on what they think might happen next, before everyone else does. Right now, they’re guessing that we are in for a long-term period of deflation. The chairperson of the Fed is predicting something quite different.
In Janet Yellen’s address last week, she went into great detail about the projections and reasoning for the moves that the U.S. monetary policy makers will pursue and why, in their dual-focused mandate of maximum employment and a stable inflation rate of 2% in the U.S.
Firstly, it’s worth mentioning that central bankers, like the Fed, only came to realize the value of a stable, moderate inflation objective as recently as the late 1990’s. Formerly, they reacted to mitigate rampant inflation or recessions with monetary policy changes. In fact, they note today that setting inflation expectations actually contributes to those expectations being met. Concerted behaviour and expectations have a significant impact on our world, and we are beginning to understand how consistently predictable we are effected by events and the anticipation of events. Whether investing in capital markets or spending money at the mall, the study of behavioural finance continues to unearth our predispositions with surprising reliability.
Central bankers in every country raise and lower the over-night interest rate to help control the economic growth of that country. Other inputs are important in determining how an economy grows, such as the price of imports and world commodity prices, but the underlying driving force is simply whether people like you and I feel financially secure enough to spend money or not.
Real interest rates are simply the nominal ‘sticker’ rates, adjusted for inflation. What is your investment in a 2% bond if the cost of living rises by 3% over the same period of time? Negative 1%! In Canada, our current overnight interest rate is 0.5%, down from 1% last January. The shock in the price of oil and the ensuing economic implications caused the head of the Bank of Canada, Mr. Poloz, to take action. By dropping short-term interest rates, it encourages people to borrow and spend rather than save. Although they could technically drop rates below zero, they couldn’t do that for very long since investors could get a better return from their sock drawer. With this in mind, you can see that the lowest real interest rate is about zero minus inflation.
In Janet Yellen’s testimony last week, she noted that payrolls have gained since the start of the year and the economy has been “expanding modestly faster than its productive potential.” She went on to note that the projections of the Federal Reserve Board indicates that as long as oil doesn’t drop significantly lower or the U.S. dollar move appreciably higher, they are projecting inflation just shy of their objectives. In terms of employment, the U.S. is near their natural employment rate but since people have been frustrated with the employment opportunities, there are a number of people who haven’t even been looking for work. The only way to entice them is to have full and plentiful employment for a sustained period. This seems to be the key priority.
As Canadians, we are keenly interested in the U.S. because they are the largest economy in the world and they are our largest trading partner, with significant implications to our own economic outlook. On our side of the boarder, the substantial drop in the price of oil, one of our major economic outputs, has impacted our economy over the last year. Nevertheless, companies have adjusted to the new commodity price and recently major producers, have announced solid footing, even increasing dividends in some cases. Furthermore, the lower Canadian dollar has attracted international shoppers and investors, which historically has translated into economic growth and inflation. Even now, the International Monetary Fund (IMF) predicts a rise in inflation in Canada this year and the most recent inflation numbers are higher for the most recent month reported.
All to say, if other investors are pricing in deflation, and markets historically overshoot the mark, there will be an opportunity to profit from the current cycle.