Weekly Update - When doves fly off… to politics

The appointment of Janet Yellen to replace Steven Mnuchin at the Treasury has reinforced our conviction that the Biden White House will pursue expansionary economic policies. During her four years at the head of the Federal Reserve (Fed), she gained a reputation as a “dove”, despite having overseen the start of normalisation of monetary policy from December 2015 onwards. Before chairing the Fed, her career spanned academia (specialising in labour market economics) and public services (for example, as Chair of Clinton’s Council of Economic Advisors).

For his part, Mario Draghi left the ECB with the reputation of having saved the euro zone. His most famous moment came in July 2012. During a speech in London, he held that “the ECB is ready to do whatever it takes to preserve the euro… and, believe me, it will be enough”. These simple words began to calm the market‘s fears. And then, a week later, he announced the creation of a new monetary policy tool, known as Outright Monetary Transactions (OMT) – this programme involves massive secondary market purchases of the most neglected sovereign bonds in order to bring their yields closer to Germany’s. OMT were never actually used but their mere presence in the ECB’s “tool box” proved enough to convince investors that Draghi’s “whatever it takes” was credible.

Draghi and Yellen’s experience as central bankers will certainly be a key determinant in their political agendas. They both presided over the launch of zero or negative interest rates and advocated the extension of asset purchase programmes in order to ensure ample liquidity and to keep the cost of bond and bank borrowing at low levels. And both placed much less emphasis on price stability than their predecessors.

During her time at the Fed, Yellen pushed for less focus on the headline unemployment rate and more emphasis on labour market exclusion and participation rates. This approach dovetails with the Fed’s new focus on “maximum employment” (see our September 4 Weekly Update) and seems particularly apposite at present. January’s job data again disappointed economists, while weekly initial claims for unemployment benefits still remain well above the highs registered during previous recessions.

For his part, Mario Draghi has kept a high degree of credibility with both investors and the Italian electorate. However, will he have the political skills to succeed as prime minister? In our view, his greatest success leading the ECB may not have been his ability to convince markets that he could save the euro. It may in fact have been his ability to convince Angela Merkel not to stand in his way, despite fierce opposition from the Bundesbank. Which stands as a testament to high levels of political skill.

Bottom line. Yellen and Draghi’s successors have held their course of extremely easy monetary policy, which has kept real bond yields (after accounting for inflation) at negative levels. And enormous asset purchases have eased the financing of ambitious fiscal support programmes on both sides of the Atlantic, which are designed to mitigate the negative effects of lockdown and to encourage a cyclical recovery in H2 2021. In this context, equity markets still have the potential to outperform other asset classes.

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