One of the key principles of financial repression is to keep interest rates below the level of inflation to get nominal GDP to rise faster than debt, so as to inflate that debt away over the long term. The world has been unable to achieve this in recent times, given the explosive growth in debt levels relative to both drivers of nominal GDP (low real GDP and inflation). The historic example often cited of successful financial repression was how the US reduced its very high debt-to-GDP levels after the Great Depression and Second World War by keeping real (after inflation) interest rates for government bonds below 1% for two-thirds of the time from 1945 to 1980. Since the pandemic has pushed debt levels in most countries to new record levels, it is unlikely that the widespread policies of record low interest rates can end any time soon.

Central banks broaden their policy scope

Apart from the more co-ordinated fiscal policy funding mentioned above, a couple of other important policy decisions were made by the world’s most important central bank, the US Federal Reserve (Fed), in 2020. The first was at the height of the initial lockdown market stress, when the Fed engineered a way to gain authority to directly buy corporate bonds, including high yield ETFs. This was viewed by many long-term Fed observers as illegal under the Federal Reserve Act, however we should never underestimate the desire for new policies to be embraced in times of crisis.

The pandemic certainly opened the door for the Fed to take much broader control of bond yields, moving away from its historic focus on US Treasury securities and into the world of capping corporate financing rates. This was also the most obvious next step for it to take, since it had taken the financial repression playbook to its historic limits, with policy rates back at the zero level and government bond yields deep into negative real territory.

In many ways the US is trailing other central banks’ evolution since the GFC. Examples of this include two central banks older than the Fed.

Other than almost monopolising its entire domestic bond market, the Bank of Japan (BOJ) has been buying Japanese-focused equity ETFs since 2013. A central bank official informed a parliamentary session earlier in 2020 that the BOJ held 77.5% of Japan’s equity ETF market (23 trillion yen’s worth)! While this is less than 10% of total listed Japanese equities, it obviously brings into question why a central bank should have a stated annual policy target to buy six trillion yen of local equities, regardless of market or economic conditions.

The other example is the Swiss National Bank, which now owns over $100 billion of US listed equities, part of its official policy target of a 20% allocation to global equities.

The other new policy decision made by the Fed was announced at the annual Jackson Hole symposium in August. After an in-depth review of its main goals, the Fed decided to move to an average inflation targeting policy (rather than a specific target of 2%), which means it will allow inflation to run “moderately” above the Fed’s 2% goal “for some time”, following periods when it has run below that objective.

While this may appear to be semantics, it is an important signal from the Fed to the market that it will tolerate higher inflation in future, implying that it will not raise rates as early as it has done in prior cycles. Given that its favoured measure of inflation, core personal consumption expenditure (PCE), has averaged marginally above 1.5% since 2009, the Fed’s idea is that, by removing the previous 2% inflation cap, it can stoke higher future inflation expectations in the US.

In the age of financial repression, this is an important change as it means the bond market is less likely to price in interest rate increases if inflation does start to rise. One of the associated implications of financial repression is pushing savers out of lower-risk fixed income assets yielding negative real returns into higher-risk, longer-duration assets, including equities.

Former Fed Chair, Ben Bernanke, was a strong advocate of this link to the wealth effect, where higher equity prices in turn increase consumer confidence, which in turn increases consumer spending and hence real GDP growth. Consequently, if the Fed’s policy change ensures the bond market accepts higher inflation for longer than it has historically, it will provide a tailwind to the equity bull market.

The other obvious way for the Fed to cap the risk of rising bond yields is to carry out further QE across the bond duration curve, now being referred to as “yield curve control,” which is a likely future policy tool if bond yields rise above inflation again.

Outside intervention in markets is not always a good thing

 With perfect hindsight, we now know that the fastest 30%+ drop in equities in Q1 2020 was swiftly followed by the fastest 50%+ rebound in history, mostly thanks to the new co-ordinated actions of central banks and governments described above. The obvious question is then: what is so wrong with policies that keep a lid on interest rates and fuel bull markets in risk assets? The risk with this co-ordinated policy mix of monetary policy directly funding fiscal policy, while potentially capping bond yields, is two-fold.

Firstly, if bond market yields do not rise to reflect the increased level of deficits and debt to fund the new fiscal stimulus, then governments will take it as a signal to fund all kinds of populist agendas that were previously seen as dangerous to countries’ long-term financial health. This in turn leads to a second risk: that if the excess money supply that is directly put into the hands of citizens is mostly spent in the economy, we could finally release the inflation genie as happened in the 1970s, shortly after the US officially moved the world’s main reserve currency, the US dollar, off the gold standard.

One of the main reasons inflation has not picked up materially since the seemingly endless money printing started post the GFC is that the traditional banking system transfer mechanism has not functioned as intended by the Fed for various reasons. This meant that new QE-fuelled money supply never found its way into the hands of citizens en masse, as has potentially just started in 2020 with these new co-ordinated policies. Instead, most of this newly-printed money put into the banking system by the Fed has found its way into risk assets. This explains the high correlation between changes in central bank balance sheets and rapidly rising risk asset prices (per chart below).