Markets’ Federal Reserve love story
The morning drive to my 11-year old daughter’s school is always fun, and often a source of insight. That was certainly the case last week when she pointed out something about Frozen, the hugely popular Disney film, that had totally escaped me. “It’s unusual,” she said, “to see a Disney movie in which they end up telling us not to marry someone we’ve just met.”
Quite early on in the movie, Princess Anna meets Prince Hans at her sister Princess Elsa’s coronation ball. They immediately connect on many levels and, yes, “fall in love.” He quickly proposes, and she accepts, but Elsa refuses to give her blessing.
It then takes Anna most of the movie to figure out that Hans is evil – set on getting rid of both her and her older sister in order to take over the kingdom. Luckily for her, there is a wonderful commoner – Kristoff – whom she has gotten to know during the course of her adventures. Unlike Hans, he is genuine and dependable; they end up together.
After many decades of Disney movies, we have been conditioned to expect princesses to fall in love quickly with their charming princes and “live happily ever after.” And when there are challenges or obstacles (mostly in the more recent movies), these are quickly overcome (and with humor).
Similarly, for many years market participants have been richly rewarded for falling in love – quickly and decisively – with the new policy measures adopted by America’s Federal Reserve. Indeed, the romance has overwhelmingly followed the Disney script. Yes, there may have been some bumps along the way, but they have been overcome quickly. And the romance has resulted in both parties living happily: the Fed feels better positioned to pursue its dual mandate of high employment and stable inflation, while investors feel that they have the opportunity for sizeable financial rewards.
This relationship has been so comfortable that market participants have adopted the mantra “Never fight the Fed” – and for good reason. The Fed is the world’s most powerful central bank. It owns the printing press that produces the world’s main reserve currency. It enjoys a significant amount of political independence. And it has not been shy about using its considerable operational autonomy.
Market participants also know that the Fed needs them to leverage its policy influence and deliver on its mandate, which, in recent years, has rightly been broadened in practice to incorporate the goal of financial stability. To this end, the Fed has become much more “transparent” with markets in the last few years, sharing more readily the minutes and transcripts of its policy discussions. The Chair of the Federal Reserve Board has even taken to holding periodic press conferences that are closely watched on trading floors around the world.
Since the 2008 global financial crisis, the romance has become particularly intense, especially as the Fed has been compelled to use a range of unconventional measures to overcome the capital-market disruptions that almost tipped the world economy into a deep depression. In doing so, the Fed has become more involved in how markets function, the valuation of assets, and fluctuations in their prices. And the markets have come to depend much more on the Fed, expecting more frequent attention and support from it (and throwing a short tantrum when they feel disappointed, as was the case a year ago).
Initially, central bankers were keen to cultivate this romance as a means of meeting their broader policy objectives of growth, employment, stable inflation, and financial stability. More recently, however, some have become less comfortable, warning that the codependence is encouraging excessive risktaking and, in some cases, bubbly valuations. Some worry that it may even undermine the Fed’s political independence. And, only two weeks ago, an outgoing Fed governor, Jeremy Stein, declared that the Fed is in the middle of a policy transition that renders its guidance to markets “more qualitative,” “less deterministic” and, therefore, less precise.
Like Princess Anna in Frozen, it will take time for markets to recognize that their relationship with the Fed is changing (and should change); and, similar to the movie, some sort of shock may be involved in socializing the new understanding. Having said that, the outcome will certainly not be as dramatic as in the movie – if only because, unlike Hans, the Fed is not out to take over the markets.
So the romance will survive, but it is unlikely to be as intense, and it is unlikely to be unconditional. The hope is that, by that time, a more vibrant real economy will perform the role that Kristoff played in the movie.
The best and most sustainable love story for markets is one based on a healthy and dynamic real economy that creates jobs and opportunities for many more people. Unfortunately, on that count, it is too soon to predict whether we will live happily ever after.