Is monetary policy based on scientific models or is that just dressing it up as more than hope? Multi Asset Fund Manager Anthony Rayner gives his take on central banks’ involvement in financial markets and what lower rates may may mean for investors.
Central banks are hoping that interest rates will have been high enough, for long enough, so that inflation will be contained and that the timing (see chart) and scale of rate cuts will be such that economies aren’t forced into recession. A smooth glide path, known as a soft landing, is the holy grail, and a pilot’s dream.
Official rates are being cut across most major economies:
Source: Bloomberg 10.10.2019 to 07.10.2024
Specifically, the hope is that easier financial conditions across economies, including consumers, businesses and governments, will be stimulatory enough but not so much so that it is inflationary. If it sounds like there is a lot of hope in this approach, that’s because there is.
Many dress monetary policy up as a science and lean on models, historical patterns and famous economists but in the end it is quite “touchy feely”, though even that is described in scientific terms, namely “data dependency”. Of course, dressing it up as much more than hope is an important part of underpinning the credibility of central banks, which allows their toolbox to be more effective.
Stepping outside the theoretical macro framework, there is a very important dynamic not yet mentioned, that of financial markets. Central banks pay a lot of attention to financial markets, as they have an important influence on the macro environment, for example through the wealth effect. This is where higher asset prices, including housing, feed positively into the macro environment, as people feel more optimistic about the future to the degree that their behaviour changes in a positive way, or conversely the negative wealth effect, which acts in reverse.
Central banks don’t deny this relationship or that they monitor it. For understandable reasons though, they are not so forthcoming about whether they target levels in financial markets, as they do for example with inflation or full employment. Their experimental adventures into quantitative easing which have left central banks owning large parts of their government bond market, or in some cases their equity market, suggest a degree of manipulation, which is not so far from targeting. Of course, publicly this is difficult to circle, as it doesn’t sit comfortably with the concept of free markets.
What should we expect from a financial market perspective in a lower rate environment? Higher rates have led many investors away from markets and into cash, particularly those with lower risk tolerances. At the same time, many advisory and discretionary portfolio managers have allocated away from lower risk funds such as defensive products and the highly diverse (often derivative based) alternatives, attracted by the improved returns from bonds and cash. As rates fall money will likely flow back into this area and funds such as the Premier Miton Defensive Multi Asset fund may come back into favour. We are already seeing interest from advisers on the back of its strong drawdown record and consistent returns since we started managing the fund just over 10 years ago.