Will the pace of monetary tightening largely depend on the Fed’s vigilant eye toward maintaining financial stability?
“I expect that the evolution of the financial system in response to global economic forces, technology, and, yes, regulation will result sooner or later in the all-too-familiar risks of excessive optimism, leverage, and maturity transformation reemerging in new ways that require policy responses.”
-Janet Yellen, Aug 25, 2017, Jackson Hole
While Federal Reserve Chair Janet Yellen provided few clues to the U.S. monetary policy outlook last week at the Kansas City Fed's annual symposium in Jackson Hole, Wyoming, she did call attention to central bankers’ watchful eye on financial stability in the post crisis world.
How central banks assess risks to price and financial stability will determine the pace at which they will withdraw monetary accommodation, one of the key risks to the global growth cycle. Since the U.S. is the most advanced in its cycle, the Fed is at the forefront of the monetary tightening debate.
In the near term, our view is that the pace of Fed tightening is less likely to derail the recovery in the U.S. The implication of this favorable backdrop is that global equity markets should see further gains driven by improving growth fundamentals.
The broad message from the Fed is that the financial system is significantly more robust now.
For four consecutive months, core inflation has hovered below 2% and it has not visibly overshot 2% for more than 20 years, even during periods of unemployment, falling well below the non-accelerating inflation rate of unemployment (NAIRU). Certainly, globalization has played a role in keeping price pressures contained, and recent technological disruption has additionally weighed on inflation. Indeed, our U.S. economist Ellen Zentner expects that the core personal consumption expenditures index (PCE) will rise only gradually and briefly touch 2.0% in July 2018.
In this context, we think the Fed will increasingly watch the risks to financial stability. Moreover, the experience of the pre-crisis period (when price stability risks were contained but financial stability risks were building up) has increased the Fed’s focus on financial stability risks in this cycle.
Previously, Fed Vice-Chair Stanley Fischer laid out the framework which the Fed uses to asses financial stability conditions, highlighting four factors: (1) financial sector leverage, (2) non-financial sector borrowing, (3) liquidity and maturity transformation and (4) asset valuation pressures.
Based on recent speeches, the broad message from the Fed is that the financial system is significantly more robust now. Hence, concerns about system-wide financial stability risks seem limited at this point. That said, the Fed has also acknowledged that parts of the financial system are still somewhat less transparent and not as well understood, which adds uncertainty.
The natural question that follows is how the Fed would respond to the buildup of financial stability risks. The Fed has, on previous occasions, pointed towards macro-prudential measures as the first line of defense to address pockets of risks in selected sectors. However, in 2014 Janet Yellen highlighted that “it may be appropriate to adjust monetary policy to "get in the cracks" that persist in the macroprudential framework”.
While the Fed has laid out its framework for assessing financial stability risks and mentioned specific metrics of leverage and private sector balance sheet health, there is uncertainty with regard to the threshold of those metrics that would trigger additional monetary tightening.
An added complication for the Fed in this cycle is that households have just exited a prolonged period of cutting expenditures and paying down debt. In essence, the Fed has to balance between ensuring that the economy is fully leaving behind the effects of the balance sheet recession and at the same time assessing and tempering a more-broad based increase in leverage.
All things considered, our assessment is that financial stability risks appear limited, though there are some pockets of corporate credit and subprime loans in the consumer space which bear watching. We expect the Fed to continue to gradually lift real interest rates over the forecast horizon, leaning against easy financial conditions, particularly as unemployment rates are already low.
Against this environment, our strategists remain bullish on equities and continue to favor emerging market currencies and, in the fixed income space, prefer local markets over external debt and maintain their higher-yielding yet better-quality bias. At the same time, they are cautious on U.S. corporate credit as signs of stress have emerged in certain sectors. The key risk to watch out for would be if the U.S. takes up financial deregulation in a way that could accelerate the pace of increase in leverage, increasing the risks of a boom-bust scenario.