Fed independence crucial for long-term stability

Text transcript

Welcome to Advisor to Go, brought to you by CIBC Asset Management, a podcast bringing advisors the latest financial insights and developments from our subject-matter experts themselves. 

* * * 

Giuseppe Pietrantonio, director and vice-president, multi-asset and currency solutions, CIBC Asset Management 

* * * 

Central bank independence, or Federal Reserve independence, is crucial for central banks, and governments and countries because mandates for central banks are very different than mandates for governments. An independent central bank means that the central bank is combating, for the most part, two things. The mandates for most central banks globally are to make sure that prices are stable over a long period of time, and make sure that unemployment is at a reasonable level over a long period of time. 

So the key here is this long period of time nature. Stability. Whereas governments themselves have a shorter time, right? We’re talking about four years of government, then that government can change. 

And so the nuance here is that to have a credible or independent central bank is crucial because they’re not swayed by any political influences. They’re not concerned in terms of increasing money supply just to help a specific need at a specific time. It’s really looking through market trends, looking through potential environments to make sure that monetary policy is stable, [and] unemployment is stable. 

Central banks can say inflation is a concern, but our policies are reflecting a longer-term mandate, not these shorter-term potential deliverables that a government may want. 

* * * 

There’s always going to be issues in specific countries. I think what we’ve seen globally is that central bank independence has been more and more important, more and more credible. 

As a firm, we invest globally. So we’re looking at global markets. And when we’re looking at the emerging markets, that credibility has been important because of what happens when a central bank is not credible or not independent. Currencies normally depreciate significantly, bond markets are less attractive, equity markets are also less attractive. It goes back to that stability. 

And so when you bring that notion back home, I think we can argue that the past 20 years — maybe even more than that— the Federal Reserve could be seen as credible. What we’ve seen in the past few months, since the inauguration of Donald Trump, is that this independence is starting to be questioned. Why? Because there’s that forceful action by the President of the United States to impose his will on the central bank. 

And whether it’s warranted or not, in terms of what the government is trying to impose on the central bank, the reality is that the market is looking at this and saying, ‘Hey, this independence has been good for markets over a long period of time.’ Once again, that notion of stability, that notion of longer-term goals. 

And so when that is put at question, market participants start to get a little jittery. They start to think about, ‘Okay, well, if the government is putting pressure on the central bank, and we have less faith in the central bank being independent, will some of the central bank’s policies reflect the shorter-term nature?’ 

And so if that is the case, market participants might be demanding higher yields, higher rates.  

So think about U.S. Treasuries, over the past year, how we’re expecting rates to come down, but 10-years and five-year Treasuries haven’t come down substantially. I think a lot is due to the market questioning is the Fed truly independent? And if they are not well, we need to be paid a higher premium to take this type of risk, because if the Fed’s not independent, that long-term nature — that long-term stability — starts to get questioned. 

And so any time there’s a likelihood or a possibility of increased volatility, that’s a risk. That’s a concern for market participants, and thus increasing the premium that people are expecting when they are investing in any asset. 

* * *  

Fed independence, in terms of its history, how it compares to other participants globally, you can argue that [in] developed markets, central banks in general have been rather credible, [employing] traditional policies, using monetary policy to combat inflation — although inflation in developed markets hasn’t been seen all that often over the past 20, 30 years. The reaction function in emerging markets is very different, where inflation is much more concerning. 

And so I think Fed independence over a long period of time has been credible, and that’s consistent with other global or developed-market countries. So I think about the Bank of Canada, the ECB in Europe, the Japanese central bank as well. Very credible in terms of what they’re trying to achieve for long-term stability. 

Policies differ a little bit, if you think about what Canada has done, the U.S. has done, Europe and Japan. Think about this recent cycle. Canada and the Euro [central bank] were quick to cut rates. The U.S. are a bit slower in terms of cutting rates. Is it warranted? You can argue, yes, it’s warranted, because growth in the U.S. has been stronger. Inflation in the U.S. has been more elevated than what we’ve seen in Canada and in Europe. And so the reaction function for the Federal Reserve, you can argue has been the same, just the inputs for the Federal Reserve are different than what we’ve seen in Canada or in Europe. 

And so in terms of credibility, I think they have been credible over the recent past — say 10, 20 years — but that credibility is being challenged in this current environment. 

If we shift to other global players in emerging markets, the independence of central banks is becoming more independent to make sure that policy within a central bank is long term. Once again, that it doesn’t differ with the short-term nature of governments. 

* * * 

If governments influence central banks, the biggest risk is to their capital markets, and to their bond markets. We’ve seen this time and time again. We’ve seen it in Turkey. We’ve seen it in Argentina. 

If I focus on Turkey as an example, central bank independence was questioned in Turkey for the past three years, on and off. Their president continues to make remarks towards their central bank governor, in addition appointing their preferred candidate. [This is] similar to what Trump has been talking about doing within the Federal Reserve, replacing Jay Powell. 

What happened is that Turkish bonds yields increased significantly. The currency has depreciated significantly. Inflation went up significantly. These are the reaction functions of markets saying, ‘Okay, well, if that central bank is not independent, where’s that stability? Where’s that risk now?’ So as an investor, I need to be compensated. 

Think about the U.S. in general. They have a deficit in terms of their capital account. Foreign direct investment is what funds the U.S. balance of payments. And so without that FDI, there’s a concern. There’s a reaction for yields to come up because you’ve got to incentivize investors to invest into your debt that you hold. 

So, [it’s] definitely a concern when we see this imposing of preferred candidate by governments, or the threat of governments to take action on central banks. [It’s a] big risk in terms of capital markets. 

* * * 

The Fed is currently balancing sticky inflation, a slowing economy and growing public debt. And so the Fed is in a bit of a tricky spot right now because the market is telling them, or participants are saying, ‘Hey, there’s inflation slowing.’ 

The government is also pressuring the Fed and saying, ‘Hey, inflation is coming down. We should cut rates. Other central banks globally have begun to cut rates. We’re late to the game. There could be a negative impulse on growth going forward because of where rates are.’  

We just lived the past three years [with] the highest inflation that we’ve seen in 20 years. And so if you try to look at different periods where we experienced this — look at the late ’70s and the early ’80s — there was an environment where we had high inflation. Inflation came down. Central banks cut rates, and then inflation re-accelerated. So I think that’s what the Fed is trying to avoid at the cost of some growth going forward. 

U.S. growth has been strong. It’s come down a little bit. It’s not negative. It’s still positive. And so I think that’s the biggest concern for governments. 

Governments want really strong growth to show, ‘Hey, we’ve achieved something, we’ve built something.’ The Federal Reserve is not necessarily always concerned about growth. They want to make sure inflation is at the right level, [and] unemployment is at the right level.  

So, once again, this dichotomy that the Fed has in terms of this balancing act is very, very tricky. 

In addition, government policy in terms of tariffs — you can ask any economist — is inflationary, and so that puts more pressure on inflation. And so the reaction function for the Fed is to keep rates higher due to inflation. 

The one other pillar that’s missing in this equation is the unemployment number. When we look at unemployment statistics, we’re seeing a softening over the past quarter. So, Q2, Q3 slowing in terms of employment in the U.S. 

And so now the Fed has got this balancing act again, trying to balance sticky inflation. We know that most central banks are cutting rates because the trend is still down for inflation, but it’s come down, but sticky now. I’ve got this slowing employment number. So that could be a concern in terms of growth. 

The balance of risk is do I keep rates higher and growth slows down, challenging my employment stats? Or do I start to cut rates now and potentially have a re-acceleration of inflation, which can, in theory, over time, lead to slowing growth? 

So the Fed is definitely in a tough spot right now. 

I think the balance of risk here is that they will cut. I think we’ll start seeing softening of inflation over the next two quarters. And so that’s going to give the Fed the ammunition to start cutting rates, and hopefully that will help employment, and that would help growth as well. 

So right now, it’s still in a tough environment for the Fed, but I think as we proceed, there’s going to be more clarity in terms of that inflation figure to help them make that decision to cut rates.

* * *

This program is intended for Advisor Use Only. The views expressed in this material are the views of CIBC Asset Management Inc., as of the date of publication unless otherwise indicated, and are subject to change at any time. CIBC Asset Management Inc. does not undertake any obligation or responsibility to update such opinions. This material is provided for general informational purposes only and does not constitute financial, investment, tax, legal or accounting advice, it should not be relied upon in that regard or be considered predictive of any future market performance, nor does it constitute an offer or solicitation to buy or sell any securities referred to. Individual circumstances and current events are critical to sound investment planning; anyone wishing to act on this material should consult with their advisor. Forward-looking statements include statements that are predictive in nature, that depend upon or refer to future events or conditions, or that include words such as “expects”, “anticipates”, “intends”, “plans”, “believes”, “estimates”, or other similar wording. In addition, any statements that may be made concerning future performance, strategies, or prospects and possible future actions taken by the fund, are also forward-looking statements. Forward-looking statements are not guarantees of future performance. These statements involve known and unknown risks, uncertainties, and other factors that may cause the actual results and achievements of the fund to differ materially from those expressed or implied by such statements. Such factors include, but are not limited to: general economic, market, and business conditions; fluctuations in securities prices, interest rates, and foreign currency exchange rates; changes in government regulations; and catastrophic events. The above list of important factors that may affect future results is not exhaustive. Before making any investment decisions, we encourage you to consider these and other factors carefully. CIBC Asset Management Inc. does not undertake, and specifically disclaims, any obligation to update or revise any forward-looking statements, whether as a result of new information, future developments, or otherwise prior to the release of the next management report of fund performance. Past performance may not be repeated and is not indicative of future results. The material and/or its contents may not be reproduced without the express written consent of CIBC Asset Management Inc. ^® The CIBC logo and “CIBC Asset Management” are registered trademarks of CIBC, used under license.