Volcker? No.

April 16, 2021

9:00 am

  • At the March FOMC meeting, Fed Chairman, Jay Powell, focussed on unemployment, especially on how persistent unemployment for the disadvantaged was a reason to keep monetary policy at a highly accommodative level, both with respect to quantitative easing (QE) and interest rates, despite strong economic growth forecasts for 2021 and rising inflation expectations. He cited the broader U-6 unemployment calculation which was at 11.1 million at the time of the Fed meeting (it had been at 7 million back in February 2020, pre-pandemic).


  • Both the April (266k vs 1000k estimate) and May (559k vs 675k estimate) non-farm payrolls figures were big misses, and these data points were used at the time by regional Fed chairs in the their daily press briefings to justify the Fed’s ongoing accommodative stance, the road being a long one and so forth.


  • The week prior to the June FOMC meeting, US May CPI printed at 5.0%, and suddenly all Jay Powell could talk about in the June FOMC press conference was how low unemployment was, how strong the economy was, and how the unemployment level would be at target levels by the end of 2022. No chat about more-inclusive or higher U-6 unemployment. Clearly ignoring inflation is fine until you get a 5% inflation print, then you ignore long-term unemployment. So much for the Fed’s dual mandate.


  • The Fed’s estimate for 2021 inflation has risen to 3.4%, a full 1% increase since March. This can be seen in the graph below from the FOMC press release, where the June data is in coloured in blue and the prior March data is outlined in blued dots. Aggregate CPI inflation year to date to May 2021 is already 2.7%, so the Fed is anticipating just 0.1% to 0.2% inflation per month for the rest of the year, which is fairly heroic. The Fed’s 2022 inflation estimate rose by 0.1% to 2.1%, again reflecting bold assumptions with respect to inflation proving transitory.

Source: Federal Reserve, as at June 16, 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • Clearly the Fed’s narrative has changed substantially. Setting aside the observation that higher unemployment and more persistent inflation is in fact stagflation, Chairman Powell explained many of the inflationary factors were still idiosyncratic and transitory, but that there was a risk inflation may be trending higher and may be stickier.


  • By way of illustration, Mr Powell talked about lumber prices, which had spiked to over $1600 per tonne in May but have since fallen back to under $1000, hence inflation being transitory. Let us ignore the fact that lumber was around $400 pre-pandemic, and so prices remain highly elevated. The real problem with this example is that lumber isn’t even a component of CPI, and therefore price changes to lumber are irrelevant to the argument Chairman Powell was making. There are two conclusions one can draw from this. Either he was unaware that lumber was not a CPI component, and therefore is incompetent, or he was aware, making him a charlatan. Take your pick.

  • Much has been made of how lumber has affected US house prices in the past 12 months (they are up around 20%), but how house prices don’t affect either CPI inflation or the Fed’s favoured measure of inflation, the PCE deflator. This argument has been used to suggest that the actual inflation level is much higher than the ‘official’ one. The housing component that does make it to CPI is ‘shelter’ and this is calculated on rents paid. As can be seen from the St Louis Fed data below, shelter fell during the pandemic as people fled the cities, but has started to rise again. This is the unpleasant, sticky inflation that the Fed so fears (as it invalidates their ‘transitory’ argument). If shelter costs continues to rise, the Fed will need to raise its inflation forecasts again, further undermining the transitory narrative.

Source: Federal Reserve, US Bureau of Labor Statistics, 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • So the Fed is changing tack. Mr Powell himself said during the press conference that ‘forecasters have much to be humble about’. Inflation may prove stickier. The plan? No longer is the Fed not even talking about talking about tapering QE, but is now potentially about to talk about tapering. The Fed ‘dots’, which constitute estimates by the FOMC board members of future interest-rate moves, are now pricing in one hike in 2023 having previously been pricing a hike in 2024. So the radical policy shift involves talking about not buying MBS at some point in the next year and maybe hiking rates once in about two years’ time. Thug life.


  • The market certainly reacted as though there had been a drive-by shooting. The DXY dollar index has traded back over 92 (a good sign of de-risking), while 10-year US real rates rose from -0.94% to -0.75% pretty much in a straight line, although half of this rally has been given back. Inflation expectations fell sharply. Much of this looked like deleveraging – the Russell 2000 substantially underperformed the Nasdaq, which is suggestive of the ‘reflation’ trade being unwound.


  • Aside from the dollar spiking, which is generally bad for everyone, the US yield curve flattened substantially. The graph below shows the US 30-year Treasury yield less the 5-year yield. The precipitous flattening of the curve looks highly deflationary. This is the stuff of policy mistakes, and yet the Fed didn’t actually do

Source: Federal Reserve, US Bureau of Labor Statistics, 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • Much of the last 12 months has been a fluffy debate between disinflation (good for bonds, good for growth equities like tech) and reflation (good for the Russell 2000, a bit bad for bond, but nothing cray cray in terms of inflation). Overall, this is the sort of goldilocks debate where pretty much all the bowls of porridge are largely just right, especially for most investors who are long bonds and long equities.


  • A spiking dollar is a major problem for all risk assets (equities, credit, and commodities) and is thus highly deflationary on a global scale, as can be seen with yield curve flattening across global rates markets following the move in the US. If the Fed responding to higher inflation means the risk of deflation, then it would appear that the market is shifting from the relatively harmless disinflation vs reflation debate to the high-stakes poker of inflation vs deflation. This is where high rollers’ rules start to come into play.


  • The last time the Fed was really hawkish was July 1994 (the month of its last ever intra-meeting rate hike). Prior to that, Fed President Paul Volcker induced what he later admitted was an unnecessary recession in 1981 all in the name of defeating inflation. That is pretty hawkish. When St Louis Fed James Bullard mentioned on Friday that the ‘tapering conversation’ might continue during the next few FOMC meetings, the markets had a fit. Gold for example, already down $120 in a week, collapsed again (see graph below, the red circle is when the Bullard headlines hit the tape).

Source: Bloomberg, as at June 21, 2021

Past performance is not a guide to the future. The price of investments and the income from them may fall as well as rise and investors may not get back the full amount invested.


  • With CPI inflation running at 5% and GDP likely to print over 6% in 2021, cutting MBS purchases from QE ought to be a nothing done. One rate hike in 2-years’ time shouldn’t be a big deal either. Yet the market has taken extreme fright. What is interesting is that the Eurodollar market, which discounts the future cost of dollars on the global markets, is now indicating a rate hike in 2022 despite the Fed dots only showing the potential for one hike late in 2023. Given the situation, this either means the Fed is about to make a major policy mistake (hiking as the US economy slows), or inflation is going to be considerably higher and more sticky than the bond market thinks.


  • It is possible the extreme market reaction is due to concentrated positioning and aggressive de-risking, and does not fully reflect underlying fundamentals. The bond market hasn’t really bought the inflation argument at all, and any hint of tapering or hiking has led it to pronounce deflation almost immediately. Whatever else this does, this suggests the Fed’s room for manoeuvre should inflation really get going is strictly limited. In fact, the Fed is likely in a trap. Due to the huge US deficit and stock of debt, it needs to keep nominal yields low (which looks deflationary) while higher inflation, which may prove sticky and pervasive, passes through the economy. Not even Paul Volcker managed that conjuring trick.


  • When asked about stagflation during the FOMC press conference, Jay Powell predictably said the Fed has all the tools but without going into any detail. Sadly for him, Powell may soon be casting a tragic Hamlet-like figure, able only to talk endlessly about all the savage tools of inflation fighting at the Fed’s disposal while the ghost of Paul Volcker stalks the corridors of the Eccles Building, demanding rate hikes. Should the inflation data remain hot over the second half of 2022, then the Fed’s credibility, especially with respect to acting, not just talking, will be tested to the full.
The information shown above is for illustrative purposes only and is not intended to be, and should not be interpreted as, recommendations or advice.

Unless otherwise stated, all opinions within this document are those of the RWC Diversified Return Investment Team, as at 24 June 2021.

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