What does average inflation targeting mean for the business cycle?
Our analysis suggests that equities and commodities stand to benefit the most from AIT extending the US business cycle.
Before Covid changed our lives and sent the world economy into recession, the US was enjoying the longest expansion in history. This period of record low unemployment was fuelled by the unprecedented easing of policy by the Federal Reserve (Fed). The Fed has recently announced that rather than focusing on reaching an inflation goal of 2%, it will use AIT.
What does AIT mean for the business cycle? To get higher inflation, AIT will allow the US economy to “run hot” for a certain period of time. The Fed will not want to put the brakes on to cool the economy until inflation is consistently above their target. This means that interest rates will stay lower for longer. So we are likely to see the overall business cycle lengthen given an extended period of economic expansion.
What does AIT mean for investing? With lower US interest rates, there will be a significant increase in financial repression (see here). To generate higher yields, investors are likely to increase their portfolio allocation to riskier assets, such as emerging market assets (see here). Our work on the US business cycle suggests that equities and commodities stand to benefit the most from AIT extending the cycle.
How will AIT change Fed’s behaviour?
AIT will mean that the Fed will not increase rates until their preferred inflation measure (PCE price index) averages above 2% for a certain period of time (see here). The Fed has yet to provide us details with what “a period” means in practice. However, we can illustrate how the central bank would have reacted in the past if AIT had been in place.
In December 2015, the Fed started increasing interest rates before inflation was above their 2% target (chart 1). If AIT had been in place back then, and if inflation needed to be on average above 2% for five years (five years being the average length of the US business cycle), then the Fed would have kept policy unchanged until now. This is because the five-year average inflation would have been below its target. Assuming interest rates stayed at zero, if not for the advent of Covid-19, the US would have carried on expanding for a bit longer. In essence then, AIT will lead to US interest rates staying lower for longer.
Interest rates matter for the length of the business cycle
Before the US entered recession in February of this year, the economy had been expanding for over 10 years. Interest rates spent almost two-thirds of this time at zero with the Fed only managing to increase rates by 2.25% in total. Compared to history, this was the least aggressive period of policy tightening during a time of economic expansion. As the Global Financial Crisis (GFC) was also followed by the deepest recession, this meant that growth was weaker compared to previous cycles.
Chart 2 shows the US business cycle divided into recessions and expansions, based on the official arbiter of recessions, the National Bureau of Economic Research (NBER). One of the shortest expansions lasted for less than a year. During 1980 to 1981, the Fed aggressively hiked interest rates by an astonishing 15.2%, which pushed the economy into recession. So the scale of policy tightening appears to matter to the length of the business cycle. In other words, the Fed can keep the expansion period going for longer with loose monetary policy.
Lower rates for longer and more positive output gaps
Another way to look at the relationship between interest rates and the business cycle is the US output gap. The output gap estimates the difference between the actual and potential GDP of the economy. Simply put, it measures how “hot” or “cold” the economy is running compared to its potential level of activity. The output gap can be neatly used to create a business cycle with four distinct economic phases (chart 3).
For instance, during economic expansions, the output gap is positive and the economy is heating up with both growth and inflation rising. In this phase of the business cycle, the Fed is likely to be tightening policy to cool down the economy.
Chart 4 shows the strong relationship between the US output gap and changes in Fed funds rates. For instance, interest rates have typically gone up when the output gap has been rising, i.e. when the economy is recovering. But there have been exceptions, for example, after the GFC, interest rates went nowhere. The Fed only moved rates higher when the output gap finally turned positive and the business cycle moved into the expansion phase.
Historically, the interest rate hiking cycle generally stops towards the end of these expansion periods. In future, AIT will allow the output gap to stay positive for longer before the Fed finally tightens its policy. This suggests that economic expansions and the total business cycle have further to go in terms of length of time than in the past.
Assets to consider during economic expansions
Looking at previous economic expansions, the performance of US equities typically exceeds that of sovereign and corporate bonds (table 1 shows the returns ranked by highest in blue to lowest in red). This is because the stock market is supported during those periods by robust earnings growth, which is a reflection of the stronger growth environment.
By contrast, rising inflation and interest rates dampen bond returns (prices have fallen while yields have increased). In particular, inflation-linked Treasury bonds have performed poorly during the expansion phases. This is likely due to higher real yields, with bond yields rising at a faster pace than inflation.
While the equity market is the top performer during the expansion phase, this reflationary backdrop has also been positive for commodities. Historically, the best phase for the commodity asset class has been during expansion periods. This is because the ramping up of economic activity leads to a strong demand for energy and industrial metals (table 2). These sectors are the most sensitive to the economic cycle. Moreover, energy commodities have a strong relationship with US inflation, given that they feed into headline consumer price inflation (CPI).
So what does AIT means for investing?
Under AIT, the Fed is likely to leave rates unchanged for longer in the expansion phase. Companies should have greater potential to deliver on earnings growth, given lower borrowing costs. This should boost the performance of equities. For the US market, this could be challenging over the medium-term as the liquidity wave has already led to equity valuations becoming expensive. To harvest returns, investors are likely to look at other equity markets or sectors, which could offer more value.
Meanwhile, commodities could shine brighter over these longer periods of economic expansion. In this cycle, the starting point for commodities also looks attractive due to the sharp drop-off in commodity prices caused by Covid-19. To get a fuller picture, however, we need to take into consideration the business cycle in China. This because China consumes half of the world’s copper production, so it matters hugely to the well-being of industrial metal prices.
Although bonds perform poorly during the expansion phase, inflation-linked bonds could deliver stronger returns under AIT. This is because inflation will run warmer than rates, which means real yields are likely be lower than those seen during previous expansion periods.
In short, AIT is likely to push investors further up the risk curve by leading them to add to their equity and commodity allocations. The risk is that this leads to greater instability in the financial system and fuels speculative bubbles in these markets. When the Fed finally puts the brakes on, the end of the next cycle (when we get through the current recession and the cycle resets itself) could be more abrupt than seen in previous cycles.