Consistent with market expectations, the Federal Open Market Committee (the FOMC) left the Fed Funds rate unchanged, at 0.25%‐0.50%. The accompanying statement was in‐line with our and the market’s expectations.
The FOMC decided the best approach was to do as little as possible and use the next few months to assess the domestic and global economic and financial landscape. Without a press conference and in light of the recent EU referendum, the prudent approach was for the FOMC to simply conduct a mark-to‐market of their June statement. Provided the data remains stable, Fed members, particularly the Chair will have ample opportunities to prepare the market for a rate hike later this year such as the July FOMC minutes and Yellen’s address at Jackson Hole at the end of August.
We can break the Committee’s statement into three parts:
Finally, one member of the committee, Esther George (President of the Kansas City Federal Reserve Bank) dissented in favor of a rate hike at this meeting. This is not the first time Ms. George has dissented from the broad group. However, she was a bit more cautious at the prior meeting and voted with the consensus.
Monetary policy is a cyclical tool used to bring forward future demand. The idea is that you can smooth the business cycle and raise inflation by lowering interest rates and encouraging people to spend and invest. The BIS recently published a strong critique of unconventional monetary policy which has gone from “exceptional and temporary” to “standard and permanent” 1. In an attempt to raise subdued inflation globally, central banks have continued to explore the monetary policy toolbox. The BIS argue that unconventional monetary policy can have serious unintended consequences that can be entirely counterproductive and hence should only be reserved for crises.
I am not as big a critique of easy monetary policy since low inflation indicates slack. However, the BIS argument does have its merits. Most economic models make a key assumption of rationality but more often than not, people are predictably irrational. Central banks have pushed nominal interest rates negative in an attempt to further reduce real rates. Whilst rational individuals should only care about real economic variables and their ability to purchases real goods and services, this is not the case in reality. It is this intersection between economics and psychology that economists often underappreciate. Theoretically, you should not care about nominal variables if you are better off in real terms, but in reality, people view negative interest rates as a tax. Ironically, it can be viewed as double taxation if it succeeds in raising inflation.
Counterintuitively, consumers may spend less when interest rates are reduced in order to maintain the same level of savings. Whilst this can occur at positive nominal interest rates as well, psychologically, the effect is probably larger as interest rates approach zero or negative.
Furthermore, it is very hard to pass on negative interest rates to the depositor and therefore they can act as a tax on banks. In Switzerland, mortgage rates actually increased to protect bank profit margins as the central bank pushed rates further into negative territory.
What does all this mean for interest rates?
Central banks will continue to fight low inflation. Whilst they recognise the unintended consequences and the limits of monetary policy, they will not give up in their attempt to achieve their (growth and) inflation mandate. They would never admit defeat explicitly. However, as their options diminish and markets become more distorted, the rhetoric for fiscal policy has stepped up. Central banks will maintain low or negative rates to facilitate larger government deficits and help sustain higher levels of debt.
Would fiscal policy work?
It depends. If the action is co-ordinated such that the market views the move as monetary financing, then inflation expectations would almost certainly rise at the expense of ending decades of central bank independence. This would cause curves to steepen globally. It is more likely such an aggressive step will be reserved for the next crisis. However, debt-financed fiscal policy is the most logical next step in raising nominal growth. Demand targeted fiscal policy would probably raise inflation, if consumers do not expect higher tax rates in the future. That said, there are many issues in the global economy that bringing forward future consumption simply cannot solve. I would prefer to see fiscal policy targeted at raising potential growth which could increase slack and be detrimental to the inflation mandate in the short term.
Ultimately, I believe yields will remain lower for longer as central banks remain extremely accommodative and fiscal policy will most likely remain debt financed and small in scale. However a political shift, either in the form of large scale fiscal policy or monetary financing, is the biggest risk to this view. For now, this remains unlikely.
1 Unconventional monetary policies: a re-appraisal, BIS, https://www.bis.org/publ/work570.htm
NOT FOR RETAIL DISTRIBUTION: This communication has been prepared exclusively for institutional/wholesale/professional clients and qualified investors only as defined by local laws and regulations.
The views contained herein are not to be taken as an advice or a recommendation to buy or sell any investment in any jurisdiction, nor is it a commitment from J.P. Morgan Asset Management or any of its subsidiaries to participate in any of the transactions mentioned herein. Any forecasts, figures, opinions or investment techniques and strategies set out are for information purposes only, based on certain assumptions and current market conditions and are subject to change without prior notice. All information presented herein is considered to be accurate at the time of writing, but no warranty of accuracy is given and no liability in respect of any error or omission is accepted. This material does not contain sufficient information to support an investment decision and it should not be relied upon by you in evaluating the merits of investing in any securities or products. In addition, users should make an independent assessment of the legal, regulatory, tax, credit, and accounting implications and determine, together with their own professional advisers, if any investment mentioned herein is believed to be suitable to their personal goals. Investors should ensure that they obtain all available relevant information before making any investment. It should be noted that investment involves risks, the value of investments and the income from them may fluctuate in accordance with market conditions and taxation agreements and investors may not get back the full amount invested. Both past performance and yield may not be a reliable guide to future performance.
J.P. Morgan Asset Management is the brand for the asset management business of JPMorgan Chase & Co. and its affiliates worldwide. This communication is issued by the following entities: in the United Kingdom by JPMorgan Asset Management (UK) Limited, which is authorized and regulated by the Financial Conduct Authority; in other EU jurisdictions by JPMorgan Asset Management (Europe) S.à r.l.; in Hong Kong by JF Asset Management Limited, or JPMorgan Funds (Asia) Limited, or JPMorgan Asset Management Real Assets (Asia) Limited; in India by JPMorgan Asset Management India Private Limited; in Singapore by JPMorgan Asset Management (Singapore) Limited, or JPMorgan Asset Management Real Assets (Singapore) Pte Ltd; in Taiwan by JPMorgan Asset Management (Taiwan) Limited; in Japan by JPMorgan Asset Management (Japan) Limited which is a member of the Investment Trusts Association, Japan, the Japan Investment Advisers Association, Type II Financial Instruments Firms Association and the Japan Securities Dealers Association and is regulated by the Financial Services Agency (registration number “Kanto Local Finance Bureau (Financial Instruments Firm) No. 330”); in Australia to wholesale clients only as defined in section 761A and 761G of the Corporations Act 2001 (Cth) by JPMorgan Asset Management (Australia) Limited (ABN 55143832080) (AFSL 376919); in Brazil by Banco J.P. Morgan S.A.; in Canada by JPMorgan Asset Management (Canada) Inc., and in the United States by JPMorgan Distribution Services Inc. and J.P. Morgan Institutional Investments, Inc., both members of FINRA/SIPC.; and J.P. Morgan Investment Management Inc.
Copyright 2016 JPMorgan Chase & Co. All rights reserved.