Monetary policy - behind the curtain

Interest rate update – and a secret revealed:

"If I seem unduly clear to you, you must have misunderstood what I said." Alan Greenspan (1926-2026), Chairman of the US Federal Reserve 1987-2006

"Pay no attention to that man behind the curtain!" The Wizard of Oz, 1939

Interest rates in 2026 are heading in the opposite direction to what money markets thought. Rates are projected to rise in the US and UK, and have already risen at the ECB. At the start of the year, US and UK rates were seen falling and ECB rates staying put.

The change in direction initially reflected Middle East conflict and the spike in oil costs, which boosted near-term headline inflation. But as the conflict has subsided – we hope – projected interest rates haven't. Clearly, other things may now be in play.

These include the stickiness of underlying inflation. This reflects ongoing economic resilience, which is keeping labour markets relatively tight, and some high profile shortages.

More recently, the new Chair at the US Federal Reserve, Kevin Warsh, may be playing a role. In contrast to the idea that he would be the president's puppet, he has taken a more hawkish tone, and promises to rein-in the academic pretensions which fostered the mistakes of 2021 (when policy took an age to respond to rising inflation).

In Europe, those mistakes may have encouraged the ECB in particular – which arguably faces less objective inflation risk – to take out "insurance" against a similar mistake now. In addition, the Bank of England faces potentially looser fiscal policy from the latest change in prime minister. (The SNB gets an honourable pass in this brief review: Swiss inflation risk is modest at the worst of times).

Whatever the exact reasons for the reappraisal, we're not that surprised by it. We had thought money markets were too relaxed to begin with. We didn't expect higher oil prices of course, but we did think a more bearish destination was on the cards. Our reading of "fair value" for interest rates is driven by our expectations of trend nominal GDP growth – and on both sides of the Atlantic, recent rates are a little below that (though much less so than in 2021, of course).

That said, the reappraisal has mattered less to stock markets than it could have done, because it has coincided with bumper corporate earnings, courtesy of the ongoing build-out in (but not yet end-user demand for…) Artificial Intelligence. How long this continues is perhaps the key investment question for H2.

Meanwhile, some longer-term monetary musings are prompted by the recent death of Alan Greenspan, the five-term Fed Chair whose cumulative nineteen-year stint – the second longest ever – started with the 1987 stock market crash and extended to the noughties' "Great Moderation". Greenspan was the best-known and most respected central banker in recent times, often referred to as "The Wizard".

In paying tribute, however, we remember that he was not infallible (and of course he acknowledged as much). His market judgement could be mixed. Speaking of the build-up to the Global Financial Crisis (GFC) he said "I really didn't get it until very late in 2005 and 2006", and his widely-cited reference to "irrational exuberance" in stock prices in 1996 came almost four years too early for that particular cycle, and at levels of valuations that subsequently became routine.

Nonetheless, if monetary policy has taken on cult-like tendencies, then he was the founder. His focus on data and detail, his public sagacity and cultivated complexity (see the quote above), and his intellectual authority, together fostered the idea of the omniscient, technocractic central banker. A big expansion in economic staff at the Fed and other central banks, and investment in complex econometric models, followed his appointment.

But as we (re)-discovered in the GFC, and again in the more recent inflation, there are limits to our macroeconomic understanding, management – and judgement. Those limits are not technical, solvable with (even) more data and modelling, but profound.

It may not be a case of our not knowing enough – after much consideration I suspect there is less to be known than we like to think – but rather, that what we do know is not always useful. Then when it comes to trying to alter things, we find that the levers we have to pull are often not connected to anything.

Changes in interest rates do affect people and businesses – but not systematically, consistently or predictably. There are many offsets and hedges, and policy anyway operates (usually) only on a small group of short-term rates. For an example, look no further than the dramatic normalisation of policy rates which occurred after 2021, and its relatively modest (barely traceable) impact on the real economy.

The secret of central banking, then, is that successful monetary policy is ultimately about credibility and mystique, not technical expertise and transparency. We know it when we see it, even if – perhaps especially when – we don't understand it. If the curtain had not been pulled back, Oz would have stayed credible.

Perhaps appropriately, an influential account of the Fed under Paul Volcker (Greenspan's predecessor, and my personal monetary hero) was titled "Secrets of the Temple"…

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