Merlin Weekly Macro: Fishing for answers at Jackson Hole

We all need a break, now and again. Time to recharge the batteries, have a change of scenery away from omnipresent screens and to park the brain in a different place to refresh itself with new and different stimuli.

For your correspondent who provides these weekly ramblings, it will be Scotland, as it usually is at this time of year. Spiritual if not permanent home, among these otherwise parched islands the West Coast will be the one place in the UK almost guaranteed to deliver rain at some stage in the ten days we are there. No matter. It is essential! The house has no mains water, instead we are totally reliant on a small burn running off the hill behind, fed by rainwater. With a full house, but being right down on the shore of a sea loch, the prospect of running out of water poses significant though not terminal challenges (but it does get a bit smelly and the loos have to be flushed with sea water which is far from ideal for the longevity of the plumbing). As soon as this is penned, we’re off, up the Great North Road. Can’t wait!

Central bankers go fishing

Talk of stunning scenery takes the focus of this week’s column to Jackson Hole, Wyoming. Even global central bankers need a break. Actually, their mini-vacation spanning 21-23 August is not so much a holiday as a working offsite. Having said which, it has the opportunity of some fishing, walking and spa time thrown in as necessary balm for the vicissitudes of fabricating monetary policy in a world in which every word they utter is dissected for hidden meaning and every action is pre-empted and second-guessed. Central bankers also know that everyone seems to think they can do the bankers’ job better than the policymakers themselves.

The symposium occasionally produces big surprises. It was in August 2020 that without any warning and with no consultation with his international peers, the Federal Reserve Chairman Jerome Powell lobbed a veritable hand grenade into the otherwise turgid and technocratic proceedings: he broke the consensus and changed the Fed’s mandated inflation target from 2% month-by-month to 2% as an “average over a period of years” without defining either the period or the starting point. A cornerstone had been pulled from the foundations of monetary policy: an absolute target, if narrow and constricting in its definition, had been replaced with one so imprecise and open to interpretation that US inflation could fluctuate widely and yet by manipulating both the starting date and the duration, the Fed would still be able to claim that the target was being achieved. Too much smoke-and-mirrors: little did Powell know that within 18 months the methodology and the policy would be tested to the limit (and would be found wanting) in the aftermath of Covid and Putin’s invasion of Ukraine and the resulting inflationary bubble. There is absolutely no doubt that had the Fed maintained the original inflation mandate, it would have moved far sooner than it did raising interest rates to mitigate against the ensuing price contagion.

Deep in the Fed bunker, tin hats are mandatory   

This year’s symposium is unusual. There is not only divergence but whisper it, dissent. In fact, for the Fed, it is worse: there is open warfare between Powell and President Trump. It is unusual and unseemly for a Head of State publicly to refer to the head of his central bank as a “loser”, a “numbskull”, having “the personality of a chair” and “no idea”, alongside “he’s the worst appointment I ever made”, particularly when the country in question is the United States, owner of the world’s strategic reserve currency. But such is where the hapless Powell finds himself with The Donald.

Powell’s crime? Not slashing interest rates from their peak of 5.5% at least to 2% where Trump wants them in order further to depress the dollar to complement his trade and tariff strategy. While Trump has backed off from his threat to sack Powell (for which he has no authority), there is open speculation as to who will be Powell’s successor as Chair when his term expires in May 2026 (he is able to remain a board Governor until January 2028). Candidates include Stephen Miran of Hudson Bay Capital, economic strategist and in the role of Trump’s economic policy adviser, the author of Trump’s trade policy.

The independent Fed is under political pressure. It is not just from an openly hostile White House: if not bullying in the manner of his boss, US Treasury Secretary Scott Bessent is nevertheless shamelessly leading the witness suggesting that not only is a quarter point cut in interest rates to 4.25% on 17 September desirable, but the recent evidence that the jobs market is much weaker than expected makes a half point cut to 4% a necessity. There is constructive internal tension within the Fed’s rate setting policy committee, much of which stems from the Fed’s confused dual mandates which currently are pulling in opposite directions. While headline inflation as measured by the Consumer Prices Index is stable but higher than it should be at 2.7%, Core inflation (which represents the official technical mandate in the inflation target and excludes food and fuel) has just risen from 2.9% to 3.1%, its highest for five months which suggests keeping rates on hold is appropriate. On the other hand, the Fed is obliged to maintain as close to full employment as the economy can support, hence the concern about that weak employment data. The market’s anticipation of a quarter point cut next month being a 95% near-certainty has been slightly diluted to 85%, with a 15% chance of no change.

It is not Powell’s business at Jackson Hole to be pre-empting what the Fed Open Markets Committee will decide in September. However, there is speculation that he might announce the removal of the “average over a period of years” codicil inserted in 2020 and return to a constant 2% target.

Testing The Old Lady’s governance

The Bank of England’s Andrew Bailey arrives in Wyoming wearing the bruises of an internal tussle within his own Monetary Policy Committee. The quarter point cut to 4% made in July, the fifth in a year, was well flagged. Priced beforehand as almost 100% a done deal, it seemed a case of nothing to see here, move on. But wait! What’s this? Not only a split decision among the MPC but an allegedly unprecedented second vote having to be taken to ensure an indisputable result that the policy decision should be to cut and not to hold. Not for the first time, Governor Bailey (cut) and his chief economist, Huw Pill (hold), were on different pages.

You expect the independent members of the Committee to be exercising that freedom of expression and voting according to the circumstances and not simply following their colleagues like so many sheep; on the other hand, it has vanishingly rarely been the case since the Bank was granted independence in 1997 to formulate monetary policy that those members of the MPC who are Bank employees (e.g. the Chief Economist) vote for a different policy to the Governor, their boss who pays their wages and appraises them annually. Disagreement following constructive and robust debate is healthy with the condition that the participants abide by the principle of collective responsibility. That this split was even-stevens and had to be re-run with a casting vote should give confidence that despite the conflicts of interest, good governance was working properly.

As to whether the quarter point cut decision reached in July was the correct one or not is a different matter: July inflation has just been reported rising from 3.6% in June to 3.8%, approaching double the target. All the Governor’s creative skills are going to be put to the test when he has to write to the Chancellor explaining why inflation is heading up and away from the target yet his committee’s policy seems inconsistent with bringing inflation back down again (it is a misconception that interest rates are fine precision instruments; they are not; they are blunt tools where the impact of a change in policy might take possibly two years to register in subsequent economic data).

The ECB’s monetary stew

The European Central Bank’s Christine Lagarde in many ways has the most complex job. She has to find a blanket policy suitable for 20 countries in the eurozone sharing a single currency and interest rate. Those members pursue 20 different and disparate fiscal strategies. She is tasked with meeting a 2% inflation target for the bloc when the national inflation rates among that group range from minus 0.9% in Cyprus to 5.4% in Estonia; Germany’s is 2.0%. Not entirely coincidentally the current eurozone average inflation rate is also 2.0%. With the eurozone deposit rate at 2.0%, it means that Estonia has a negative real interest rate of 3.4%, Germany’s is zero while Cyprus has a real positive rate of 2.9% (and a government budget deficit of 8.4% of GDP when the economy is only growing at 0.5%). In reality, policy is largely dictated by the economic needs of the bloc’s big guns: Germany, France, Italy and Spain but much energy is expended holding the eurozone together when systemic cracks start appearing between its members.

A politician to her fingertips (French former government minister and head of the IMF) Lagarde was actively being courted this summer to lead the World Economic Forum whose own spiritual home for the Global Great and Good is Davos. She is adamant she will remain in post at the ECB until her term expires in 2027.

Seeing the wood for the trees

Leaving aside the preoccupations with short term interest rates, what these central bankers should be spending a lot of time deliberating is the rapidly changing world, their role in it and their influence upon it. They should be scanning from 30,000 feet rather than grubbing about in the weeds.

They should be asking themselves searching questions about whether they and their predecessors share any responsibility for the polarisation in politics in the western democracies. For two ex-bankers it was of direct relevance: Mario Draghi, formerly of the ECB, briefly became Italy’s technocrat prime minister of a government which failed to master populist politics; former Governor of the Bank of England Mark Carney today finds himself as Canada’s prime minister (or in Donald Trump’s mind, Governor of the 51st State of the Union.)

As we have described many times in these columns, the decade-long experiment with quantitative easing (QE) might have seductively suppressed financing costs, but the resulting linear positive correlation of asset values in bonds, equities and property created a cavernous wealth gap between the ‘haves’ and the ‘have-nots’, those with assets and those without. It was former Chairman of the Federal Reserve Bank of New York Bill Dudley who raised concerns about the social ramifications of QE more than a decade ago. Political polarisation, populism and fragmentation create less predictable outcomes which add to risk.  Further, prolonged QE unwittingly helped propagate the “zombie economy” with a fall in real wages, a deterioration in productivity and a downward step-change in economic growth rates. Countries subject to QE accrued surpluses of under-productive labour and capital as the economic inefficiencies arising from perpetually cheap capital and an over-supply of liquidity eroded the necessary (if occasionally brutal) principles of Darwinian economics.

As the ECB reaches a zero real interest rate in the eurozone (where the rate of interest and the average inflation rate across the bloc are identical), the next phase will be whether to drop interest rates further, once more returning to negative real rates as a means of loosening policy. It and other central banks should ask themselves critically, what did a decade of ultra-loose policy do the last time? Is it something we should be repeating (the UK and the US are still a considerable way from this conundrum, but that should not stop them in the context of what next, when we get there)? They should ask themselves a fundamental question: if the repayment of debt is an obligation, should it not always carry a positive real rate of interest? The cost would remind the borrower that while temporary debt is acceptable, taking the attitude that it can become effectively permanent by refinancing it on the never-never has severe economic consequences and also raises financial risk levels.

The Fed and the Bank of England are both concerned about their governments’ fiscal predicaments. Persistent large deficits are surely unsustainable. But both central banks wilfully helped fund such enduring deficits almost without constraint (in the case of the ECB, completely without constraint when its nominal negative interest rate policy was paying eurozone governments to borrow) and for more than a decade. Was that wise?

They should be looking at their own diminishing influence. Spanning 2022-4, the biggest hikes in interest rates seen in peacetime were seen as the harbingers of inevitable recession. Economies have slowed, certainly, but despite the debt burden, the impact of tighter conditions has not been nearly as great as many feared. Why? Does it therefore also mean that the current loosening cycle will be less stimulatory than might have been anticipated?

Finally, the shifting sands dictating the balance of power between the central banks and the markets: central banks used to control the money supply; with the rapid, universal development of the bond markets for financing, that is no longer the case. Does that automatically mean the central banks are able to exercise less economic leverage? Money supply talk naturally leads to the systemic threats posed to economic sovereignty by crypto currencies for one of which, inevitably, Donald Trump is his own issuing authority and banker-in-chief.

There is no doubt plenty more but that should keep them busy for a while. It might still leave them a few minutes to tickle a trout or two, steam in a sauna or wander in and wonder at the wilderness around them. It’s hard work being a central banker.

The Jupiter Merlin Portfolios are long-term investments; they are certainly not immune from market volatility, but they are expected to be less volatile over time, commensurate with the risk tolerance of each.  With liquidity uppermost in our mind, we seek to invest in funds run by experienced managers with a blend of styles but who share our core philosophy of trying to capture good performance in buoyant markets while minimising as far as possible the risk of losses in more challenging conditions.