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Every year in August, the US Federal Reserve holds its annual summer symposium in Jackson Hole, Wyoming. This event represents an important data point for financial markets because it provides valuable clues as to the policy moves the Fed may make in the ensuing twelve months. This year was no exception and investors should have listened carefully to what was communicated. Strangely enough, they usually choose not to, resulting in some market volatility but also opportunities for active investors.
This year, Jackson Hole gave us a whole lot of what we already knew: The US Federal Reserve won’t rush rate hikes, also because inflation is no real worry. This is in part due to the “fourth industrial revolution” that we are currently in, spearheaded by digital technological advances in areas such as the fifth-generation telecommunication standard (5G).
The ongoing advance of technology, the age of digitalization, is often referred to as the fourth industrial revolution. As a quick recap, these are the four industrial revolutions:
It is interesting to note that industrial revolutions and low interest rates go hand in hand. The first and second industrial revolutions coincided with the 64-year Victorian age when the UK was the predominant global superpower. This period was marked by great technological changes, a lack of major military conflicts and low rates. So, a decade-long low-rate environment isn’t a new or unique phenomenon. Then as well as now, widespread technological advances tend to have a disinflationary effect on the economy, and this is what we are witnessing at the moment.
Against this backdrop, the Fed’s caution not to rush things as communicated again by Chairman Jerome Powell at Jackson Hole, is understandable. The Fed has experienced disinflation during the past ten years up to the pandemic due to great disinflationary forces, including digitalization, that still prevail. Digitalization started with the introduction of the iPhone (the hardware) and is now followed by 5G. At the beginning of last year, we believed it would change the industrial world because there would be more connectivity between devices and machines. But then came the pandemic, and what we saw since the start of Covid-19 was a different kind of connectivity, not device-to-machine, but device-to-device. Indeed, it was a brutal stress test as, from one day to the next, we were cut off from friends, loved ones, and our colleagues – we were told to stay home and work from home.
As humans, we are quite resilient and we bounce back – and we did bounce back by overcoming these new challenges. Our new isolated existence pushed us to find new ways to communicate. We adapted to this eradication of face-to-face meetings by embracing connecting apps and platforms such as Zoom, Teams, WebEx, or Skype. We went from saying “it’s really important that I fly to Singapore tomorrow” to “on second thought, a video conference is just as good.”
The surge in connectivity we have experienced during the lockdowns has enabled many of us to keep working from home. However, many employees in service sectors such as the hospitality industry were left sitting at home without a job.
After the 2008 global financial crisis, we saw that service-sector jobs declined, but then, they never really recovered to pre-crisis levels. Now, with the Corona crisis and our transition to using apps rather than face-to-face services, we don’t expect a significant rebound of service-sector jobs either. The still slack labor markets, plus reduced consumption, mean that inflation drivers remain scarce, requiring interest rates to remain low “for longer” (potentially even “forever”) to keep economies humming along.
At last year’s Jackson Hole gathering, the Fed introduced the “Average Inflation over Time” (AIT) framework, giving itself more flexibility to react to inflation. The central bank has since remained firmly committed to it. Over the past twelve months, Mr. Powell has been re-iterating that the Fed won’t raise rates pre-emptively, even if there should be signs of the labor market overheating or inflation accelerating. One key component of the AIT framework is the Fed’s focus on actual data rather than just forecast data. This comes against the backdrop of inflation readings missing or undershooting the Fed’s own forecasts from 2012 to 2020. We have had disinflation for a decade up to the pandemic, and the Fed wants to be very careful before making rate moves on inflation.
The second key component of AIT lies in the acronym: Average Inflation over Time. What matters for the Fed is for inflation to take hold and be sustained. Therefore, I think that they are looking at inflation prints over an extended period, at least three years, rather than just a few inflation data releases. Looking at three-year rolling core personal consumption expenditures (PCE), for instance, would be more appropriate. This measure is likely to stay below the Fed’s 2 percent target in 2022, hence its patience. The hurdle for rate hikes due to inflation is extremely high under the new Fed framework and the lack of negative inflation surprises at Jackson Hole reinforces this.
Since the Fed was quite vocal about being patient this year in light of their new AIT framework and not acting pre-emptively based on forecasts but wanting actual data, it might choose to reinforce the framework by addressing a persistently uneven employment picture alongside a low average inflation environment. The theme of this year’s symposium was “Economic Policy in an Uneven Economy,” focusing on the uneven employment picture partly driven by advances in technology and digitalization. This implies that the Fed would be unlikely to consider reducing asset purchases unless the labor market manages to achieve broad-based and inclusive gains.
Lael Brainard, a member of the Fed’s Board of Governors, was quite clear on the preconditions that would need to be met before the Fed moves closer to any “tapering”, i.e. the withdrawal of the Fed’s extraordinary support measures. She would like to see: “indicators that show the progress on employment to be broad-based and inclusive, rather than solely focusing on the aggregate headline employment rate”. Her most recent remarks on July 30 in Aspen, Colorado, indicated that unemployment remained high – disproportionately among African Americans and Hispanics and lower-wage workers in services. According to her office, there was still a significant shortfall in prime-age, low-skilled workers in June. This amounts to a shortfall of 9.1 million jobs compared to the pre-pandemic trend – a special Fed indicator.
Given this backdrop, tapering asset purchases were talked about at this year’s symposium but not triggered, as yet. With substantial slack remaining in the labor market and the pandemic continuing, an ill-timed policy move according to Jerome Powell would represent “a mistake that could prove particularly harmful“. Hence, there is no substitute for a careful focus on incoming data and evolving risks implying that the Fed’s rate-setting body, the FOMC, should not open the door to triggering tapering at their next meetings unless the labor market manages to achieve broad-based and inclusive gains in this short period of time. “Whilst employment has brightened considerably in recent months,” according to the Fed chief, there is still much ground to cover to reach maximum employment and the conventional unemployment rate indicator of 5.4 percent “is still too high, and this reported rate understates the labor market slack”.
Another factor to delay tapering further into 2022 is the downside risk associated with the Delta variant of the Covid-19 virus. In many areas, vaccination rates are not as high as we would have hoped and may dampen the rebound in the services sectors that account for three-quarters of the shortfall in jobs, according to Lael Brainard. This would suggest that we would still have some distance to go in achieving substantial further progress in employment before beginning to slow asset purchases.
It’s worth remembering that during the global financial crisis of 2008, broad-based labor market conditions only showed very slow improvements with a Fed being accommodative and quite patient. This could repeat itself this time around especially given the greater advances and rapid implementation in digital structures. With regards to Europe, the European Central Bank (ECB) is likely to follow in the Fed’s footsteps given that job polarization is also a key concern for ECB President Christine Lagarde.
Overall, shifting the “lower-for-longer” regime seems difficult in an uneven and digital economy. The central bankers have a big task on their hands to keep the global economy humming along, and inflation should be kept in check due to the disinflationary nature of digitalization and 5G connectivity. We have to think in eras because digitalization is the fourth stage of the industrial revolution, and such processes are typically multi-decade. Under this lower-for-longer environment, we are comfortable with the risk and the attractiveness of corporate bonds in the developed markets and believe that active investors are still in a good position to benefit from selective investments. And this holds true for many years to come.