Looking for Policy Pivots

Policy often has a major influence on financial markets, usually much more than wars or disasters or other headline news events that appear more dramatic. Most people don’t pay much attention to policy developments since it is often pretty boring stuff. At the moment, however, it is front and centre for all investors.

Economic policies come in various forms and employ various instruments. Trade policy uses tariff and non-tariff barriers to encourage or discourage the flow of goods and services across borders. Regulatory policies tend to be industry specific and rely on changing rules for businesses. Fiscal policy refers to the spending and taxation decisions of the economy and can be very political. Tighter fiscal policy typically means the government takes more out of the economy and puts less in. Loose fiscal policy – funded by borrowing - is the opposite. Monetary policy is usually the preserve of technocratic independent central banks, who set interest rates free from political interference to achieve low and stable inflation. Increasingly in the aftermath of the 2008 global financial crisis, central banks also have a greater focus on maintaining the stability and functionality of the overall financial system. We recently saw an example of the financial stability goals coming into conflict with the inflation targeting objective in the UK when the Bank of England stepped in to prevent a bond market meltdown and curtail the sharp increase in bond yields even as it continues to raise the Bank rate. We are likely to see more such cases as pressures build across the global financial system with the widespread and sharp hikes in interest rates everywhere.

One would hope that when authorities change policies they do so for well thought-out logical reasons, but often it can be irrational, self-serving and short-sighted. At worst, they can be completely counterproductive.

However, even at the best of times, changes in economic policies have unintended consequences. It is virtually impossible to think of and avoid every single outcome when changing a key input in a complex economic system. There are also always winners and losers. Sometimes, the losses are concentrated and immediate while the gains are diffused and gradual.

Moreover, policymakers often have very blunt instruments to deal with specific problems. The current global inflation surge is due to a combination of supply-side and demand-side forces, but interest rates only work to affect demand. Higher interest rates cannot increase the flow of gas into Europe or produce more food or replace the “missing” workers in many developed economies.

Rates still rising
As fiscal and particularly monetary policies have tightened worldwide, investors are now looking for pivots towards easing. Since much of the pressure on financial markets comes from relentless interest rate increases, any signs of things going the other way will be greeted with cheer. One of the more aggressive central banks in the developed world has been the Bank of Canada. There was a flurry of excitement when it hiked by 50 basis points instead of 75 basis points last week. However, this hardly counts as a pivot. It is still tightening.

In the case of Canada’s southern neighbour, there is also optimism that the pace of rate increases will slow in the coming months. While possible, the Federal Reserve is still likely to take its policy rate to around 5% early next year. This level is likely to be maintained for some time until inflation is on a clear and convincing path towards the 2% average target and staying there. The Fed’s preferred inflation measure, the core PCE deflator, registered a 5.1% gain for the year to September. While the pace of price increases is slowing levelling off, it is still a long way from 2%. One of the key inputs in the Fed’s decision-making framework is the strength of the labour market. When workers are scarce, they can bid up wages which forces companies to raise prices, particularly in the service sector. With unemployment near 50-year lows, the signals from the job market also point to higher-for-longer interest rates.

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