How the World Is Messing With Investors and the Fed

Policy makers and investors might need to get new playbooks

By Justin Lahart

The Federal Reserve in Washington. In a speech late Thursday, Fed chief Janet Yellen said the central bank aims to raise rates later this year. Photo: Andrew Harnik/Associated Press

The world is messing with the Federal Reserve’s plans. Investors should be able to relate.

Fed Chairwoman Janet Yellen in a speech late Thursday said the central bank aims to raise rates later this year. In doing so, she made the case that despite last week’s decision to keep rates on hold, trouble overseas wasn’t likely to have a significant effect on future policy decisions. The crux of her argument rested on a view that reduced unemployment will push wages higher, leading inflation back toward the 2% that the Fed has targeted.

One risk to that view is that overseas economies’ ability to influence U.S. prices may have risen to the point where the inflation the Fed expects to see in the years ahead won’t come.

That has implications for investment allocation decisions. Traditional moves into or out of, say, stocks and bonds might not make as much sense this time around.

To understand why, consider the relationship between a falling unemployment rate and rising wages.

This is named the Phillips curve after one of the economists to first identify it and forms the backbone of economic models used by Ms. Yellen and her staff. But the Phillips curve relationship has been spotty lately.

The last time the Fed’s preferred inflation measure excluding food and energy prices was up 2% on the year was in April 2012, when the unemployment rate was 8.2%. Since then, core inflation has fallen to 1.2%, and the unemployment rate to 5.1%.
One reason why: With increased globalization and the rising clout of developing countries, issues overseas are playing a greater role in U.S. inflation than in the past. The sum of U.S. imports and exports, for example, now amount to nearly 30% of U.S. gross domestic product, compared with 20% in 1990. Over the same period, the developing world’s share of global GDP has risen to 40% from 20%.

As a result, lower import prices that have come about as a result of the dollar’s rise and weakness in China and other developing economies matters more than in the past. And they may continue to weigh on inflation well into next year. Indeed, according to Johns Hopkins economist Jonathan Wright, futures-market implied inflation expectations suggest that the Labor Department’s consumer price index will be up by just 0.35% on the year next June. That points to an inflation environment where the Fed, if it does raise rates this year, will have a hard time raising them thereafter.

It isn’t just the Fed that’s in a muddle. Investors have long based allocation decisions on where they think the U.S. is in the business cycle. This is first characterized by strong growth with low inflation (buy bonds) and then strong growth with rising inflation (buy stocks).

As the Fed clamps down, there is weakening growth and too-high inflation (buy commodities), followed by weakening growth with falling inflation (retreat to cash).

A more global investing environment—U.S.-based companies have more substantial overseas operation than before, for example, while the role of the U.S. economy in setting commodities prices has been diminished—makes a hash of that. Uncertainty about the Fed only makes the picture more complicated.

Both Fed policy makers and investors might need to get new playbooks.

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