Fed repression could turn to Fed regret

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.

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. This drove a search for yield amongst investors, who poured funds into bonds and equities, particularly those which could promise consistent dividends.

Through its asset purchase programme and forward guidance, the Fed has succeeded in easing broader financial conditions. It has crushed interest rates along the yield curve and driven down yields across credit markets, which now also fall within the central bank’s asset purchase remit.

Loose policy from the US affects assets around the globe as the Treasury bond yield is often seen as the global interest rate, thus setting a benchmark for asset prices.  Central banks elsewhere have yet to follow the Fed’s suit, but savers already face an extended period of low short rates as their economies battle Covid-19.

Two risks that accompany financial repression

Whilst the economic outlook warrants such a loose policy, two risks in particular stand out from the increase in financial repression.

One is that it has a counterproductive effect on spending, by simply forcing people to save more to meet their investment goals. The reduction in bond returns hits annuities and forces people to increase their savings to generate the same income. This so-called “paradox of thrift” could hamper efforts to boost consumer spending.

Corporate and local authority spending can also be affected through the same channel as their pension funds face increased liabilities from a lower discount rate, forcing increased contributions and/or cuts in spending. This has already weighed on US spending where local authorities have had to make cuts to prioritise pension payments, for example.

The greater risk though may be through the effect low rates have on markets. Although markets are currently cooling, the Fed’s powerful liquidity boost from loose monetary policy is set to continue for another three years unless inflation picks up significantly, something we do not expect.

The result could be an increase in financial instability and even bubbles in asset prices as investors chase returns in markets.

Fed plan could come back to haunt it

Today, the banks are more heavily regulated and central banks have developed tools – macro prudential policy - to control the financial system. Yet, whilst the banking horse is back in the stable, there could be risks elsewhere in the system.

One danger would be that investors choose to enhance returns with cheap leverage, which would make the system more vulnerable to a bust. Investors could be sucked into an unsustainable bubble, leaving many with losses.

Having controlled inflation rather too well for the past decade, the Fed has now rebalanced its remit toward maximum employment, seen as a means of tackling inequality. Investors are grateful to the Fed for supporting markets which had threatened to seize up in March during the Covid-19 driven sell-off.

However, the price for support has been the suppression of volatility and a loss of opportunity to make returns and meet savings goals. The cost of such financial repression could well be market instability and speculative bubbles, which may well come back and bite the policy makers come the bust.