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"Don't fight the Fed"

April 23, 2021

reading time: 5 minutes

by David Wolf, Head Research Content & Publications, LGT

Despite rising inflation, the Federal Reserve wants to maintain its monetary policy until the end of 2023. What does the comeback of inflation mean for investors?

National banks have powerful tools in place to exercise monetary policy. To maintain their credibility, the monetary watchdogs constantly strive to ensure that these instruments are effective and that they remain assertive in their political activities.

Even though no one seriously doubts the power of these institutions' bag of tricks, the negative interest rates and experiments with other exotic monetary policy measures in recent years have undermined investors’ confidence. Did and do the central banks still take hold of the reins? Considering this current low interest rate environment, do they have the possibility at all to react adequately to a change of assumptions or a change of pace on the interest rate markets?

When Google announces skepticism

If nothing else, this mistrust is due to bad experiences from the past. Google, for example, reported a conspicuous increase in searches for “hyperinflation” as soon as the Federal Reserve launched a new program to expand money supply.

Major monetary devaluation has failed to materialize in the recent past. Nevertheless, the fear of the return of the specter of inflation persists. It is hardly remarkable, then, that with last year's Federal Reserve (Fed) response to the outbreak of the Corona pandemic, the old familiar prophecies of doom have increased inflationary.

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A little over’s okay?

Since then, the discussion about the new glut of money has been omnipresent and has meanwhile also been reflected in inflation expectations. The M2 money supply increased rapidly in the USA in 2020, i.e., money has actually come into circulation in contrast to earlier monetary and fiscal policy easing, which served, for example, to boost the capital buffers of financial institutions rather than stimulating the economic cycle with banknotes or liquidity.

M2 money supply increased abruptly in the U.S. in 2020

Meanwhile, the US Federal Reserve is keeping its feet on the ground and is facing the rise in inflation calmly. It considers the current development to be temporary and therefore does not see itself under pressure to abandon its expansionary monetary policy and raise interest rates in the next two years.

Fed chief wants to unleash the economy

US-Notenbankchef Jerome Powell.
US-Notenbankchef Jerome Powell (© Keystone/AP Photo/Manuel Balce Ceneta).

Federal Reserve Chairman Jerome Powell has only recently explained that the rise in long rates of ten to 30 years is due to a solid economic recovery. Also, the Fed already announced last year that it would tolerate inflation rates of over 2% in the short term and considers the 2% inflation target as an average value over an entire economic cycle. In other words, there is a willingness to temporarily unleash the economy.

Are we facing a new era of higher inflation and a cautious Federal Reserve? Or are we simply dealing with a risky bluff? Should the Fed adhere to its announced strategy, there will be consequences for equities and bonds.

Why one should not bet against the US central bank

No matter what approach the Fed pursues, investors are always well-advised not to bet against its policies. “Don't fight the Fed” is an investment principle that advises aligning the portfolio with the current monetary policy of the US Federal Reserve System and not fighting it.

For if the central bank pursues its policy with virtually unlimited funds, asset prices will inevitably shift. And as a small investor, one should not get in the way of this steamroller. This generally means taking more risk on the equity side when interest rates are low or falling, and being more conservative when interest rates are high or rising. Currently, interest rates are low, so the main question is how long the Fed can remain relaxed towards a rising consumer price index.

Welcome inflation

With the loose monetary policy, the expansion of the central bank’s balance sheet and direct donations to American private households, both the monetary and the fiscal money floodgates are wide open. This has unleashed a growth of savings deposits. It used to be different, for example, during the great financial crisis when politics was still pursuing an austerity policy.

According to the Fed, it is easier to fight high inflation than permanent deflation triggered by a premature tightening.

David Wolf, Head Research Content & Publications

Even though this fact may explain the noticeable rise in inflation, there is no evidence that the Federal Reserve is losing control. The current yield curve seems to support the equity markets and investors expect the economic recovery to continue. According to the Fed, it is easier to fight high inflation than permanent deflation triggered by a premature tightening.

This is in line with the announced passive course until the end of 2023. The well-known dot plot of the Fed's US Open Market Committee, which captures the interest rate expectations of the monetary watchdogs, coincides with the verbal communiqués of the Fed committee. In contrast, the market expects the next interest rate step quite a bit earlier at the end of 2022. Fortunately, the market is already prepared for a potential change in the Fed's rhetoric.

Our expectation: The Fed will continue its set course in the near future

The Federal Reserve as a national bank is obviously only one of many market players investors should keep in view. But the US Federal Reserve is the alpha dog in the pack of monetary watchdogs and through its balance sheet, it carries considerable weight for the international financial markets.

Nevertheless, it currently seems unlikely that the Fed will tighten its monetary policy solely based on notoriously volatile inflation indicators. It assumes that the US economy is currently at a turning point and has just entered a period of growth and recovery of the labor market.

No action is likely until the economic data point to the risk of overheating, and we won’t be there for a while yet. Both treasury and the central bank would like to see inflation rise - investors should take this seriously and position themselves accordingly.

In this market environment, equity markets and risky assets should actually benefit and we continue to see a relative attractiveness of equities over bonds. But the favorable refinancing opportunities of recent times have left their mark. A few highly-rated, unprofitable companies in the market were able to build a sensational Wild West façade thanks to cheap loans. So now is the moment for scouring the portfolio and reconsider any hyped positions. As soon as the Fed tightens the interest rates, it will be too late.

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