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INFLATION - WE GONNA LET 'ER RUN HOT!
Position your portfolios accordingly
I have little time for main-stream economists. If someone drags out a DSGE model or injects some heavy econometrics into their analysis, I tune out. Maybe I am not being fair. I accept that criticism. But I have never found any of these traditional economic theories help me make a single dime in the market. Not only that, many of their theories are just plain wrong.
Lots of people like to take potshots at Krugman. I am no exception. He seems to epitomize the modern-day-main-stream-economist. And no MacroTourist post mentioning the good-doctor would be complete without my all-time favourite Krugman meme.
Why do I pick on him? His failure to accept the broken window fallacy is just one reason, but there are lots of others.
Mainstream economists' inability to understand why they have been unable to create inflation since the Great Financial Crisis is another example of their failing.
It is therefore with a great note of irony that I noticed a recent change in rhetoric from the Federal Reserve.
From a recent FT article:
The Federal Reserve is considering introducing a rule that would let inflation run above its 2 per cent target, a potentially significant shift in its interest rate policy. The Fed’s year-long review of its monetary policy tools is due to conclude next year and, according to interviews with current and former policymakers, the central bank is considering a promise that when it misses its inflation target, it will then temporarily raise that target, to make up for lost inflation. The idea would be to avoid entrenching low US price growth which has consistently undershot its goal. If the Fed adopts this so-called “make-up strategy”, it would mark the biggest shift in how it carries out its interest rate policy since it began to target 2 per cent inflation in 2012. Policymakers are frustrated by the failure of prices to hit their target even as US unemployment has plumbed 50-year lows. The new policy would require “making it clear that it's acceptable that to average 2 per cent, you can't have only observations that are below 2 per cent,” Eric Rosengren, president of the Federal Reserve Bank of Boston, said in an interview with the Financial Times last week.
The FOMC Board is setting the table to let inflation "run hot". It's funny because they basically don't have a clue why they haven't been able to make more inflation up to now. Yeah, sure they will argue that the three D's (debt, demographics, and disinflation from technology) have hampered their ability, but their models said they should have been able to overcome those forces.
Now before you message telling me your moral objections to a Central Bank actively pursuing inflation, save it for someone who is interested in debating how the world should be. I have no desire to go down that road. When it comes to this letter, I care more about forecasting the policies that will be adopted rather than those that should be adopted.
It seems clear to me the Federal Reserve has changed its tune. Until now, the 2% inflation target has acted more like a "ceiling" than a "target". The crew at SL Advisors created this terrific chart that illustrates this point:
If the 2% inflation target truly acted as an average, there should be points above and below the 2% bulls-eye. It should look like the dartboard on the left. Instead, it looks more like the right-handed board with all the readings coming in below 2%.
The Federal Reserve has just told you - in plain English -that they have abandoned their "inflation ceiling" mentality and will truly adopt a 2% average target. Past periods of sub-2% inflation will, therefore, need a corresponding equal amount of time above 2%!
The most amazing part of this development? The market couldn't give two shits.
The Fed is literally telling you that they won't feel the need to hike rates when inflation rises above target, yet this is greeted by a collective yawn.
Now I understand where investors are coming from... at least partly. Monetary policy is no longer driving this bus. The market realizes easy monetary policy cannot in of itself create inflation. I get it.
Yet, the Federal Reserve could still derail an economic expansion with overly aggressive tightening. This happened in 2018. The United States government did a highly stimulative fiscal expansion and it was completely offset with Powell's raising of interest rates. Powell nipped any chance of the global economy running "hot" in the bud.
But now the Federal Reserve has given the message; "we hear you that we screwed up last time and we won't do it again!"
Why the bond market is not more horrified by this progression is beyond me. Inflation is coming. The last defender just waved the white flag. Position accordingly.
Thanks for reading,