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Podcasts from Confluence Investment Management LLC, featuring the periodic Confluence of Ideas series, as well as two bi-weekly series: the Asset Allocation Bi-Weekly and the Bi-Weekly Geopolitical Report (new episodes posted on alternating Mondays).
Welcome to the Confluence Investment Management Bi-Weekly Asset Allocation Report for July 29, 2024. I'm Phil Adler. As the Federal Reserve this year delayed interest rate cuts, signs of impatience have become more evident. For one thing, we've read and heard opinions in recent months questioning the current working relationship between the Fed and the federal government known as Central Bank Independence. Bottom line seems to be that the Fed might be more responsive to the desires of the people if the executive branch exerted more influence.
Phil Adler:Confluence Investment Management Associate Market Strategist Thomas Wash joins us today to discuss the price we pay for central bank independence and takeaways for investors. Thomas, first, just how independent is the Federal Reserve Bank, really?
Thomas Wash:Phil, that is an excellent question. While many believe the Federal Reserve operates independently, Congress and the president ultimately sets its primary goals, which include price stability, maximum employment, and moderate long term interest rates as outlined in the Federal Reserve Act of 1977. However, the Fed enjoys considerable discretion in determining the specific tools and strategies to achieve these objectives such as setting interest rates and conducting open market operations.
Phil Adler:How did we arrive at this this current relationship of independence between the Federal Reserve and the Federal Government?
Thomas Wash:Well, the foundation for the Federal Reserve's independence was laid in the aftermath of the Korean War. During the conflict, the central bank supported government financing by maintaining low interest rates, which included yield curve control. However, rising inflation prompted concerns about the policy's efficacy. This led to a contentious standoff between the Federal Reserve and then president Harry Truman, ultimately culminating in the Treasury Fed Accord of 1951. Now this agreement granted the Federal Reserve greater autonomy to use monetary policy tools for achieving macroeconomic objectives establishing a president for the central bank's role today.
Phil Adler:But just to be clear, there are no laws governing this independent
Thomas Wash:status. Yeah. So let's just say it's a bit of a gray area. As a semi autonomous organization, the Fed has powers that other agencies simply don't. For instance, it can set its own budget and generate its own revenue.
Thomas Wash:Now this independence has led to demands for more oversight, but that's neither here nor there. That said, the Fed isn't completely unchecked. Congress keeps an eye on things by making the Fed chair testify about decisions and their economic effects. Plus, the president picks the Fed's board of governors, and the senate approves them, giving them a big say in who makes policy.
Phil Adler:Well, since the seventies, investors have come to expect that the Fed will raise interest rates to bring down inflation and will cut interest rates to stimulate the economy. Has this been an effective strategy?
Thomas Wash:Well, the market seems to think so. Paul Volcker's aggressive monetary tightening dramatically shifted investor sentiment. By demonstrating a resolute commitment to curbing inflation even at the cost of economic pain, he reassured foreign creditors. This newfound confidence underpinned the historically long bond bull market that recently concluded. However, critics argue that the Federal Reserve has been overly hesitant to raise rates in recent years, maintaining excessively low rates for way too long.
Thomas Wash:This policy, they contend, has fueled government spending and contributed to the current economic challenges.
Phil Adler:Thomas, as as you point out in your report, what benefits financial markets doesn't always translate to political popularity. Does this boil down to a reality that politicians desire quick solutions while bankers have a longer term view?
Thomas Wash:Let me say this. Investors fundamentally abhor uncertainty. When governments inject substantial spending into the economy, there's a heightened risk of overheating, which leads to inflation. Now to counter this, investors crave confidence in the Federal Reserve's ability to swiftly raise interest rate at the first sign of inflationary pressure. Now this assurance is crucial for investors to feel adequately compensated for taking on risk.
Thomas Wash:Lawmakers, on the other hand, they prefer borrowing costs to be lower as it will help lead to more jobs and higher consumption, which aid in their ability to be reelected to office.
Phil Adler:Thomas, there there are even some concerns voiced today that by raising rates, the Fed might be contributing to inflation instead of managing it because the price of housing, both purchases and rentals, goes up in tandem with rates when supply is constrained. Do you think there is validity to this argument?
Thomas Wash:While the theory that higher interest rates can sometimes lead to higher inflation has gained traction, it's tough to isolate the impact definitively, especially with factors like labor shortages and soaring material costs hindering housing construction. Now the Fed remains focused on taming overall inflation by dampening demand, and they're seemingly less concerned about potential supply side effects. Plus, the Fed has stuck to its guns on focusing on overall inflation numbers rather than drilling down into specific price increases.
Phil Adler:Thomas, how does today's rising federal debt complicate the, the relationship between the central bank and lawmakers?
Thomas Wash:Well, the Federal Reserve's interest rate hikes have dramatically increased the government's borrowing costs. In fact, these costs now exceeds defense spending. Consequently, the government's capacity to issue new debt for initiatives like tax cuts or expanded Social Security benefits is significantly constrained.
Phil Adler:What might be the dangers of a situation where we see a weakened central bank operating under a revised framework which requires the Fed to consult with the president on interest rate decisions.
Thomas Wash:In our view, the loss of the Fed's independence would fundamentally change how people view US dollar denominated assets. Historically, when faith in the dollar has eroded as it did when Richard Nixon closed the gold window in 1971, investors have sought to diversify away from the dollar to protect themselves from potential currency debasement. As a result, a weakened fed could lead to a significant shift in global investment preferences away from US assets.
Phil Adler:So would you say independence is a key to credibility and credibility is key to the Fed's efforts to contain inflation.
Thomas Wash:Yeah. You know, I think that's an interesting way to frame the question. Essentially, you're asking about the Fed's credibility and its impact on market confidence and inflation expectations. While both are crucial, I believe the Fed's credibility is more critical for market confidence. Now investors use financial assets as a vehicle to transfer savings into the future.
Thomas Wash:Now inflation is a key factor in calculating the expected return on these assets or risk premium. Therefore, the Fed's role in shielding investors from inflation risk is important for financial markets. However, the Fed's ability to influence people's expectations about inflation is uncertain. Most people base their ideas about future prices on what they're actually paying for things, not on what the Fed does.
Phil Adler:Would you say the price we pay for central bank independence is a slow growth or even declining economy for longer periods of time?
Thomas Wash:Yeah. You know, I I would agree with that. An independent central bank serves as a crucial check on government overreach. By insulating monetary policy from political pressures, the Fed can prioritize long term economic health over short term electoral gains. This prevents policy makers from resorting to inflationary policies or excessive debt spending to win elections at the expense of future prosperity.
Phil Adler:And has there been fairly broad agreement in the past that the price of a slow growth economy is worth it if inflation is contained?
Thomas Wash:Yes. Many people agree that a politicized Federal Reserve can contribute to excessive government spending. You know, before Paul Volcker, presidents frequently pressured the central bank into maintaining low interest rates to stimulate the economy despite the Treasury Federal Court of 1951. The Nixon Burns and Carter Miller relationships exemplify this trend. Now the resulting rampant inflation of the 19 seventies 19 eighties is a stark testament to this current era.
Thomas Wash:Ironically, Volcker's aggressive monetary tightening is lauded as a great triumph in American history despite the fact that it caused a double dip recession.
Phil Adler:Do you think, Thomas, that possible challenges to central bank independence will begin to lose steam as rates come down?
Thomas Wash:I'm not that optimistic. The political climate is so tense that any action by the Federal Reserve will likely be perceived as benefiting one party over another. So, for example, former president Donald Trump has expressed his opinion that the Fed should not cut rates before the election. At the same time, Elizabeth Warren has criticized the Central Bank for not lowering rates sooner. As a result, conversation over Fed independence will continue whether or not they cut rates in September as the market expects, and this will not change no matter which party wins the White House in November.
Phil Adler:Do you see any sign, Thomas, that increasing attention to the usefulness of Central Bank independence is affecting the markets today?
Thomas Wash:We're getting some signs of that. You know, it it looks like the market is starting to worry that the Fed might not be as independent as it used to be, but this isn't exactly new. We think the big market move toward the end of 2023, as we call it the feds, you know, fake out about interest rates going down was actually the central bank and the treasury working together. In our view, they were trying to stop long term bond rates from getting above 5%. So the feds talked about cutting rates and the treasury shifted its borrowings to short term debt.
Phil Adler:Does Confluence Investment Management have an opinion on whether the Fed will, in fact, become in time less independent of lawmakers and the effect this might have on investment strategy?
Thomas Wash:Well, it's it's hard to say for sure, but things are looking like the central bank might have to give up some control as the government's debt problem gets worse. We think gold could be a good way to protect your money from this risk. If people will start losing faith in the Fed's independence, they'll probably wanna own less dollars and start exploring alternative assets. Gold could be a good way to do that given its history and track record as a currency debasement asset.
Phil Adler:Thank you, Thomas. Our discussion today is based upon sources and data believed to be accurate and reliable. Opinions and forward looking statements expressed are subject to change without notice, and this information does not constitute a solicitation or an offer to buy or sell any security. Our audio engineer is Dane Stoll. I'm Phil Adler.