(Bloomberg View) — Financial markets are no longer just a barometer. Now they can cause storms.
We can see two reasons that this happened: Active investors switched to autopilot, and economic regulators became followers rather than leaders. We can also see two outcomes: perverting the function of markets and creating new uncertainties in the economy.
The decision by investors to shift from active to passive investing over the past several years is understandable. High fees in traditional active-management products like mutual funds didn’t make sense when lower-cost products like exchange-traded funds were introduced. On balance, the former rarely outperformed the latter over time after fees. In recent years, low returns and lack of volatility have created the same competitive disadvantage for high-fee alternative investment products like hedge funds. A seven-year bull market in both stocks and bonds domestically has reduced the value of hedges in portfolios. And the scars of the dot-com bust and 2008 financial crisis have created lingering distrust of Wall Street. Maybe some investors would like to minimize their interaction with the industry: Just buy an ETF and call it good.
The same crisis that eroded trust in Wall Street also shook Federal Reserve officials’ confidence in their economic models and worldview. The financial crisis blindsided the policy makers charged with preventing such a fiasco, and in recent years, growth and inflation have undershot their forecasts consistently. As Bloomberg’s Matthew Boesler reported, officials are fundamentally questioning their framework for understanding the economy.
In recent months, Chairwoman Janet Yellen has cast doubt on the link between a stronger labor market and inflation. A recent Fed study also noted the breakdown in the relationship between inflation expectations and actual inflation over the past 20 years. The Federal Open Market Committee meeting in August 2008, a month before Lehman Brothers filed for bankruptcy, noted that inflation expectations remained elevated. That did not pan out.
What are the implications of investors stepping away from active management, and the Federal Reserve losing confidence in its models? Moving away from one belief system implies moving toward a different one, either knowingly or unknowingly.
In a June 30 speech on the macroeconomic outlook and monetary policy, St. Louis Fed President James Bullard noted that he now looks at macroeconomic outcomes in terms of regimes, with different regimes requiring different monetary policy. But he said that regime changes are not forecastable. By giving up on forecasting changes in regimes, the Fed is deferring to real-time economic data and financial market prices rather than its models, a shift that has large implications for both markets and the economy – rather than markets responding to changes in the economy and from policy makers, the causality may flip, with the economy and policy makers reacting to changes in markets.
Financial markets are supposed to be the output of the collective decisions of all market participants. If buyers of financial assets are more motivated than sellers, then prices will rise until a new equilibrium is found. But even as markets have become increasingly influential, they have grown to reflect input from fewer sources. Market signals no longer convey a broad consensus among many buyers and sellers.
Passive investors accept the market price, regardless of how the price was arrived at. The primary marginal buyer or seller of individual stocks is becoming corporations, deciding whether to buy back stock or issue new stock. Fixed-income markets are becoming more and more dominated by fund flows, both from foreign central banks purchasing bonds and from pension funds looking for stability as more baby boomers retire. By deferring to the wisdom of markets, the Fed is in essence ceding monetary policy to a few powerful players.
When the next economic storm tosses the U.S. economy, once-complacent investors will suddenly ask: Who’s steering this thing?
To contact the author of this story: Conor Sen at firstname.lastname@example.org. To contact the editor responsible for this story: Philip Gray at email@example.com
This article originally appeared on WealthManagement.com-----