Policy Divergence And Investor Implications

by: CFA Institute Contributors

By Mark Harrison, CFA

The world's central banks and treasuries are no longer simply balancing the levers of growth and inflation through a succession of cycles with varying degrees of poise. Karin Kimbrough, a macro-economist at Bank of America Merrill Lynch, explores a world where all the old symmetries of monetary and fiscal policy have evaporated - that era might as well be 100 years ago.

Instead, according to Kimbrough, who spoke at the CFA Institute Fixed-Income Managed Conference in Boston, in this new era, central banks are far from scoring top grades. In the United States, the US Federal Reserve's quantitative easing (QE) trade is beginning to unwind, but QE policies are still underway in other developed economies. There is monetary and fiscal policy divergence, which, together with demographic distinctions among advanced economies, has important implications for interest rates and fixed-income markets.

In this question & answer session following Kimbrough's presentation, concerns are raised about this policy divergence, difficulties controlling inflation, portfolio risk concentrations from investor yield-chasing, and perceived foreign threats.

A full version of this presentation is also available in the CFA Institute Conference Proceedings Quarterly.

Audience member: What do you think about the concept of good versus bad inflation?

Karin Kimbrough: I personally do not ascribe too much value to the good versus bad inflation concept. I think that the good versus bad inflation argument really just reflects where we see growth and demand more tightly. We are making more advances on the consumer side. Growth is looking okay, and services are definitely stronger than manufacturing, so we are seeing more inflation in services. Any sort of price pressure from abroad is just completely disinflationary given the strengthened dollar and the many downward pressures abroad in commodities and import prices.

You mention that fiscal policy is not living up to its end of the bargain. What are some policies that you would espouse to help bridge the gap?

I am a Keynesian at heart, in the sense that Keynesian is shorthand for correcting deficient demand. I believe that, in the presence of a deep lack of aggregate demand, the government should step in and support it. So, as a Keynesian economist, I would have supported some kind of new deal deploying people who are still unemployed to work on a major infrastructure project. It might be a redo of some of our major highways or getting high-speed internet into more rural areas - some long-term infrastructure investment that would actually pay off in dividends in the long term for the United States in terms of productivity, either through transportation or communication.

So, I would have liked to have seen highway bills and infrastructure bills or, as a New Yorker, another tunnel between New Jersey and New York. All of that got delayed because it was deemed too expensive, but I cannot think of a better time to do it than when rates are low and there is a lot of labor to deploy. Yes, it is expensive, but it also puts people back to work. When people are back at work, they are paying taxes, paying their mortgage, and shopping, and businesses make plans and invest.

When you grade inflation a D+, you grade it against the Fed's target of 2%. How do we know 2% is the right number? If 2% is not the right number, what might the right number be, and how would it affect your grade for inflation?

I graded it based on the test, and the test was 2%. Should the test be different - say, 1.5%? Maybe. I think of it this way: 2% provides a nice, comfortable margin such that the Fed is not setting a target that is so low that it is constantly flirting with deflation, which is generally a nightmare for central banks. No central bank wants to be constantly resorting to QE and asset purchases.

The Fed wants to be able to toggle the pace of our economy using rates, which is hard to do when everything is sitting so close to the zero lower bound. A 1% inflation target would mean that, over the medium term, actual inflation is oscillating at a very low level, which is problematic. The Fed is trying to set inflation expectations that give the central bank ample room to respond without constantly facing a threat of either destabilizing high inflation or managing problematic deflation. No one is quantitatively arguing the Fed get to 2% more robustly than historical behavior.

If 2% is just a random number and is not achievable, does it force the Fed to implement policies that might create other risks, such as the systemic risks that come out of an attempt to create something that is not possible?

Central banks look at a variety of measures when deciding on policy, and of course, not all measures point in the same direction. For example, the personal consumption expenditure (PCE) index presents a more negative case right now compared with consumer price index (CPI) inflation, which is sitting at 1.7-1.8% - a lot closer to 2%. It depends on how something is measured, and of course, governments and central banks are guilty of occasionally changing their standards. They will give good reasons for changes - for example, they might say, "We think we need to reweight medical costs or housing costs differently" - and they will come up with a different measure of inflation.

If 2% is indeed unachievable and we are constantly trying to drive ourselves there, then perhaps we are doing it at the expense of inflating asset price bubbles by keeping rates unusually low. I think about it from a central bank perspective: There are risks of financial instability resulting from inflated asset prices. These risks are worsened when leverage is added into the mix. Right now, I do not think we are at a particularly over-levered position relative to a decade ago. So, the Fed might be willing to tolerate some degree of overvaluation in certain markets, because the leverage does not look like it is there. That said, if leverage were building up, I would be a lot more worried about trying to achieve an unachievable target of 2%.

Disclaimer: Please note that the content of this site should not be construed as investment advice, nor do the opinions expressed necessarily reflect the views of CFA Institute.

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