The new role of the Fed

The Federal Reserve, like every other central bank, is tasked with a mandate of maintaining monetary stability. According to the orthodoxy of economic theory, it does so by means of a monetary transmission mechanism, adjusting the overnight rate at which it lends to commercial banks, thereby influencing the cost of credit throughout the entire economy.

At least, that’s what the economics textbooks tell us.

The reality is something very different. As many of us in markets are keenly aware, there is what the Fed does, and there is what the Fed says. Add that to the fact that markets are forward-looking, and things are hardly as simple as traditional economics teaches.

The use of “Forward Guidance” as a monetary policy tool was the topic of a paper published by the Fed in May 2021, entitled “The Emergence of Forward Guidance as a Monetary Policy Tool”. The introduction juxtaposes two very opposing views to its use, with George W. Mitchell, Fed governor in 1966, noting:

“It is true there are no adjectives, no judgments and no explanations of present actions or inaction in these [Federal Reserve] statements and reports; nor are there tips, predictions, threats or promises of future action. Nor, given our present state of knowledge, does it seem desirable or appropriate that there should be.”

It follows with a quote from former Fed chair Ben Bernanke from 2011:

“Influencing the public’s expectations about future policy actions became a critical tool.”

This contrast in opinion underscores the state of play. Yes, the Fed does influence economic behaviour to some extent, specifically when it comes to the demand for credit. Particularly in highly indebted economies, the stock of debt and the associated costs of interest to finance that debt makes consumer behaviour very sensitive to cost of financing. But it does so not only because of the said monetary transmission mechanism.

Rather, it does so by creating and managing expectations. As important as what they do is what they say they will do. This is true of all central banks, but there is no question that of all of the world’s central banks, the Fed is the most influential of them all.

This ability to influence forward expectations is the closest thing to “mind control” one could come up with outside the realms of science fiction. The best thing is it actually works, to the extent of being highly efficacious. For years, a mere utterance in one direction or another was enough to move the needle on financial conditions – even if the actual rates weren’t touched, the prospect that the levers might be pulled was enough to elicit a reaction in the market.

Efficacious doesn’t necessarily mean beneficial, however, and the side effect of that efficacity is that the Fed has cultivated a set of rather inconvenient habits in the market.

And it has now fallen onto the Fed to correct these habits.

Creatures of habit

One of the most fascinating concepts from the world of statistics and data analysis is the idea of hysteresis. “Hysteresis” shouldn’t be confused with “hysteria”, although both are arguably present in the markets we are now so familiar with.

Wikipedia defines Hysteresis well: Hysteresis is the dependence of the state of a system on its history. Put differently, hysteresis describes how the state of a system tends to “lag”, with influences from past behaviour continuing to persist. This applies to both the physical world (e.g. the deformation of rubber bands and shape-memory alloys, or the basis of memory storage in hard disk drives), to statistical data and perhaps also to the behaviour of market participants in aggregate.

It is this memory that forms the habits and rules of thumb that characterise market behaviour. Hysteresis comes in two forms: rate-dependent and rate-independent, with the key difference lying in whether the system retains a persistent memory of the past even after the transient influences have died down. Now we’d like to think that as market participants who are fundamentally human (even algos are written by humans), we’d have the ability to move on from the effects of transient influences over time, but even so, the length of time and intensity of a transient influence determines how long the memory persists.

Intuitively that makes sense: the older the habit, the harder it is to change them.

A quick search on Google suggests that it takes on average 2 months before a new behaviour becomes automatic, although that number could range anywhere from 18 to 254 days. No surprise then that after what the writer Nassim Taleb calls “fourteen and a half years of Disneyland”, not only has the economic structure of the world been upended, an entire generation has also lost its perception of the time value of money.

With interest rates at close to zero, alongside a persistent belief in the presence of a “Fed Put” that ensures markets don’t go down, some dangerous habits have been formed. Not only are we referring to market behaviour: “YOLO” trading in daily options, meme stocks and a general disregard for risk in the pursuit of “one trade to make it all”, not to mention the persistent belief in “buying the dip”; we also refer to general economic behaviour: the financialisation of almost everything, stemming from a belief (rightly so, in the context of the past 14 years) that savings are futile and that an abundance of low-cost liquidity will always be available, even if ownership of any real assets (e.g. real estate) becomes ever further from reach.

Humans are creatures of habit, and even when we train algos, we train them according to those habits. If it takes 2 months for behaviour to become automatic, imagine what 14 years can do to the way we think, not just about trading in markets but also the world in general.

As we’ve discussed before, the past 14 years might have been great for markets, even if the balance in the market’s structure became ever more distorted. The rise of passive dominance in market flows as well as the outsized influence of options on their underlying markets (rather than vice-versa) are but two of the biggest counter-intuitive consequences of these circumstances.

But they were great because of the absence of one major factor: inflation.

Before, as it is now

The absence of inflation offered central banks around the world, not just the Fed, a reason to push interest rates to rock bottom. After all, in the aftermath of the GFC, the fear was that a recession would persist and worsen into a depression, so demand had to be stimulated in order for economies to grow out of their quagmire.

Yet year after year, despite persistent rounds of QE, inflation never seemed to pick up. Growth came, sure, but from the perspective of central banks, if inflation remained low, then surely there was still slack in the economy, and that gap needed to be filled with more monetary stimulus.

With hindsight, we can now see that central bankers made the same mistake that they have only recently realised in the current state of play: that inflation (or disinflation) can be caused by supply-side factors too, and those supply-side factors are squarely out of the realm of influence of monetary policy.

Just as the inflation that we are experiencing now has less to do with “overheating” economies than a stark shortage of supply, the lack of inflation that characterised much of the last 14 years was less to do with a shortage of demand, than an abundance of supply, particularly structurally exported disinflation from China as the world’s manufacturing base, not to mention the huge stimulus in infrastructure spending post GFC which in itself triggered a commodity supercycle at the time.

The consequences of potentially misreading the reasons for a lack of inflationary response to the scale of monetary easing have now been laid bare for all to see: financialisation has led to habits being formed, of seeking optimality over redundancy (aka “fragility”), of liberally taking on financial leverage and most profoundly of believing that above all, markets were too big to fail, what with 401k plans and pensions etc, and that political pressure would always lead to central banks bailing everyone out if the market goes down.

Indeed, former President Trump’s references to the S&P 500 as the barometer of the economy’s well-being were perhaps the culmination, rather than the beginning, of these beliefs becoming common knowledge.

Everything became about the market, so if the market is strong, then surely the economy is strong. Politicians want to remain elected, so they have the make the economy strong, and logically they would need to make the market strong. Therefore, markets only ever go up right? Right??

What is water?

At risk of overquoting these lines from the late David Foster Wallace, we once again recall this parable from his speech in 2005:

There are these two young fish swimming along, and they happen to meet an older fish swimming the other way, who nods at them and says, “Morning, boys. How’s the water?” And the two young fish swim on for a bit, and then eventually one of them looks over at the other and goes, “What the hell is water?”

For fourteen years, all of us have been swimming in the water of easy monetary policy with near-zero inflation. But taking a step back, this is more than just about fourteen years. It is about more than thirty years of generally low and falling inflation, especially in the US, which ultimately influences Fed policy, which in turn influences global monetary conditions.

Source: https://fred.stlouisfed.org/series/FPCPITOTLZGUSA

Sure, there have been bouts of inflationary impulses, but what we’ve had was more than 30 years of low, stable inflation, a goldilocks scenario for markets.

That spike at the right side of the chart started post 2020. And if we fail to recognise that the water in which we’re swimming is the water of low and stable inflation, and that the water conditions about to change drastically, that’s going to be problematic.

It also doesn’t help that anyone who had any experience trading the markets in the environment of the years between the post-war era until 1980 is probably retired by now. As a result, we have an entire generation of investors (ourselves included) who have never had to ride through an inflationary environment.

The task laid out for us is to work out how to get through to the other side.

Breaking the habits

Whatever the plan may be, it’ll most likely involve breaking the habits and beliefs that applied during the past few goldilocks periods. At the very least, it entails acknowledging that these habits are in play. But that’s the difficult bit.

A quick scroll through Twitter or Reddit will reveal a chorus of “buy the dip” variations. Even where many rightly proclaim that we “should not fight the Fed”, there remains a strong belief that the Fed is simply trying to talk its way into tightening, rather than actually doing it.

In terms of trying to “read” into the Fed’s intentions, we need to look no further than Fed Chair Powell’s speech at Jackson Hole late last month: not even 10 minutes long, he begins by specifying that his “remarks will be shorter, my focus narrower and my message more direct.” The next sentence says it all: “The Federal Open Market Committee’s overarching focus right now is to bring inflation back down to our 2% goal.”

To paraphrase the quote from George W. Mitchell from earlier, there is not shortage of predictions, threats and promises of future action in Chair Powell’s speech.

Furthermore, in the weeks that have followed, we have seen no shortage of other Fed governors come out to hammer the point through: that rates need to be higher for longer, that single data points don’t change the Fed’s trajectory, that inflation needs to be trending down consistently before any change in direction is considered.

This is as forward as Forward Guidance can get.

Yet, earlier this week, heading into the CPI data release, we once again saw the market attempt to front-run the still-elusive “Fed Pivot”, the hope that suddenly inflation would look a little tamer and the happy times of easy money would resume. An 8.3% inflation print promptly took the wind out of the sails of that ship. Next week, we have the September FOMC meeting taking place. Will the market continue to work on the basis that the Fed is bluffing?

The habits of the past decade, and especially the past 2 years, remain strongly entrenched, not least thanks to the efficacity of the Fed in conditioning those habits. But habits don’t take into account changes in environment, and as the Fed is undoubtedly finding now, that past efficacity is leading to the market exhibiting hysteresis, acting in opposition to the outcomes it desires: a tightening of financial conditions, rather than a loosening of it when the market positions for Fed easing because of the likes of “the Fed put”, “up only” and “buy the dip”.

The process of breaking a habit is painful – the relapses into the old ways make it an arduous one. But it is necessary for there to be any form of tenable solution to the change of market regime we are experiencing, from the water of low/stable inflation to one of high and sticky inflation.

The role of the Fed (and every other central bank) is therefore much more than simply executing on monetary policy. It must use its tools, including that of forward guidance, brought into the orthodox policy toolkit by Ben Bernanke, to correct the habits that its prior policies engendered.

Hopefully this influence works as well when it comes to tightening policy as it did with loosening policies.

And hopefully this helps the market to kick some habits that are less appropriate in a changing regime.

Eugene Lim