PATRICE RASSOU: Dancing to the Fed’s tune

Two years ago, at the annual Jackson Hole economic symposium, US Federal Reserve chair Jerome Powell announced a new monetary policy framework which involved two key changes. 

The first was that if US inflation  remained below 2% for some time, the Fed would allow it to run “moderately” above its target of that number as long as it could keep it about there for an “average” over a period of time.

The second change was to ensure full employment by responding to a tight labour market — when there are many vacancies and few people out of work —  only when signs of inflation became evident. In other words, the Fed would not react by pre-emptively hiking rates,  but would rather fall behind the curve until inflation became clearly evident.

Unfortunately, such vague language only served to sow the seeds of uncertainty for investors.

By the end of last year, US unemployment had fallen below 4%, but total employment was still below pre-pandemic levels as many workers reconsidered their options. Many people who did not have the luxury of working from home and remained hesitant to return to the office due to the new variants of the Covid virus either decided on new careers or exited the workforce completely, leading to the so-called great resignation.

Perversely, a combination of strong stimulus, government benefits which boosted household savings and record low interest rates pushed US inflation past the 7% mark in 2021, to 40-year highs. To make matters worse, global supply chains were still struggling to get back to normal, with car production worldwide hitting the brakes. Finally, the Fed members opted to end asset purchases by March 2022, opening the door for rate hikes.

Powell’s flexible average inflation targeting appeared to have failed. And yet US President Joe Biden chose to renew Powell’s term for four more years. Russia’s war in Ukraine served only to pour oil on the inflationary fires. This forced the Fed to pull the emergency handle in June with a jumbo rate hike of 75 basis points (bp), the largest since 1994. 

Some in SA may ask: “What has all this got to do with us?” It would indeed be a good question, as the Reserve Bank has been ahead of the curve, having started  its rate hiking programme last November — well before its US counterpart.

But since then, our Reserve Bank has   appeared to be playing catch-up, hiking 50bp in May and then 75bp in July, in lockstep with the Americans. With another strong US jobs report out last Friday, the risk is now that the US central bank may be forced to continue in the same vein at its next meeting in September. It means Reserve Bank governor Lesetja Kganyago  has to make the difficult decision for SA to continue this “dance macabre” when it next announces a rates decision on September 22.

The Americans, though, appear to have one clear advantage over us. The Fed, for now, has accumulated sufficient credibility to have its bond market dance to its tune. US 10-year treasury yields peaked at close to 3.48% in June, only to start a steady decline, falling below 2.6% earlier this month.

Monetary policy is a blunt weapon and can only really make a dent on inflationary pressures by driving the economy into recession, as we saw in the stagflationary era of the 1970s. Yet the US bond market appears to be discounting just that. In contrast, SA’s 10-year government bond yield rose from 9.4% in February to more than 11.4% in July, only pulling back after the Bank’s surprise 75bp hike last month. Setting aside the recent pullback to just below 10.65%, and excluding the blowout during the Covid crisis of 2020, we have to go back to the global financial crisis of almost 14 years ago to get to similar levels.

The primary role of most central banks is to ensure price stability in the economy. This is particularly important as inflation erodes first and foremost the purchasing power of the most vulnerable members of society.

While the Bank has credibly anchored SA inflationary expectations in the 3%-6% range for years, it appears that in the near term, monetary policy will remain constrained through a virtual policy arms race by the Fed to fight rampant inflation. This is unfortunately not good news for an economy yearning for growth and jobs. 

Rassou is chief investment officer at Ashburton Investments