• The best part about the Fed’s FOMC meetings is the two-week blackout period prior to each one in which we are blessed with a brief interlude of silence. In the week starting 21st June, there were sixteen speeches or interviews held by senior Fed officials, three by James Bullard of the St Louis Fed alone. This follows the actual Fed FOMC meeting just the week before in which all their views were recorded as a matter of public record. Sadly for everyone, the market mood music of 2021 is being provided by the Fed’s PhD-heavy mariachi band from hell.
The Fed – still annoying diners with a performance that is anything but transitory
- 2021 has however been notable for growing discord amongst the various Fed luminaries. 2020 was an easy sell – the market collapse in February and March as well as the shutting down of the economy provided an obvious justification for Fed intervention. With US May 2021 CPI printing at 5.0% and May core PCE at 3.4%, the dissonance between the dovish camp (Kashkari, Williams, Brainard et al) and the more hawkish group (Kaplan and Bullard amongst others) is a little more discernible.
- Some of these troubles are of the Fed’s own making. In 2020, the Fed changed its inflation goal from 2% in the medium term to one where overshoots above 2% were to be tolerated, with a view to effecting an overall average of 2% inflation, in part to compensate for a prolonged period in the past where inflation had fallen below 2%. By doing this, the Fed has forced itself into a debate about how long the market can be expected to turn a blind eye to obviously higher inflation while it is making up for previous periods of ‘under-inflation’. One means of doing this is getting the Fed speakers to drone on constantly about how the inflation is transitory and should be tolerated, without blowing up the bond market.
- This is quite a task the Fed has set itself – trying to keep inflation expectations anchored around 2% even in the face of what appears to be rampant inflation in certain parts of the economy, especially for day-to-day items like food. When people start paying more on a daily basis for the stuff they eat, common sense suggests this may be a good starting point for inflation expectations to become unanchored. The other problem the Fed has is that the very policy of tolerating more short-term inflation may well act as a catalyst for inflation expectations to become unanchored. Given we know that for now at least the first Fed rate hike will only come in 2023, their only substantive policy tool at present is ‘open mouth’ policy, hence the daily jibber-jabber about inflation being transitory.
- Public figures seem to have a knack these days of producing soundbites which aren’t simply inane but which are also tautological in a boringly unironic way. An honourable mention in this department goes to former-British Prime Minister Theresa May for her “Brexit means Brexit” classic. The Fed’s ‘inflation is transitory’ very much falls into the same category. They may as well go on the wire most days and claim that water is wet.
- The obvious rejoinder to the ‘inflation is transitory’ statement is the question “when is it not?” This is where the Fed can be at its most weasel-like since inflation is a rate of change measure without beginning or end. With an entirely straight face therefore, President of the Atlanta Fed Raphael Bostic said on the 23rd June that high inflation will be “longer than we expected initially”, lasting perhaps 6 to 9 months not the initially-expected 2-3 months.
- June marks the end of the base-effect argument. Inflation is a measure of year-on-year price change where the current month’s prices are measured against those of a year ago. Volatility in inflation caused by instability in the previous year’s data are called ‘base effects’. April, May and perhaps June 2021 will all likely show big jumps in prices against the lockdown-affected equivalents in 2020. If Mr Bostic is saying that high inflation will last longer, then he is clearly undermining the base-effect element of the argument. This has been a key part of the Fed’s transitory thesis thus far.
- With ‘transitory inflation’ a tautology, the Fed is perfectly capable of continuing to peddle the same argument and the market can keep going along with it. Inflation may be 5% now, but since the Fed isn’t going to hike until 2023, equities hit new highs again last week. The party goes on. If however you look below at the long-term graph of US CPI, you’ll note that inflation has been permanently transitory since about 1971 – indeed the inflation shocks of the 1970s are barely discernible in the graph.
Source: Fred, as at 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.
- One of the major shortcomings in economics and financial market analysis in general is its unconscious reliance on relative analysis dressed up in the clothes of comparative analysis. In the hard sciences, abstract scales exist against which two objects can be measured and the data compared. When measuring temperature for example, we still use the terms hot and cold but these are relative (‘today is hotter than yesterday’ and so on). However, we also have various fixed scales (Fahrenheit, Celsius, Kelvin) which are objective (water always boils at 100°C at sea level) which permit the objective comparison of data through place and time.
- Economics often has a different point of departure. For example, much of it is concerned by the relationship between the rich and the poor. Rich and poor are relative concepts (‘richer than’ and ‘poorer than’) and roughly correspond to the primitive observations about things being hotter or colder than something else (i.e. in the absence of a scale of measurement such as Celsius). The rich vs. poor debate doesn’t even translate between those who are say poor in the first world versus those who are poor in the third world, let alone across longer periods of time (France’s Louis XIV for example got considerably worse medical care than that provided by the most under-funded NHS trust despite being the sun king). Much of economics ought therefore to be considered subjective as it is relative.
- In data from June 2021, the following different inflation measurements can be observed: May CPI at 5.0%, May PCE deflator 3.9%, University of Michigan 1-year inflation expectations 4.2%, TIPS 1-year break-evens 3.17%. All of these measures are different – they are calculated in different ways, have different components, use different time horizons and so forth. There are several more, and it is hard to say which is right. Talking about inflation as a general topic, and especially talking about it being transitory, is a bit like having a definition for acceleration without first having decided what speed itself is.
- There are various ways to look at the causality of inflation depending on which economic ‘school’ one belongs to. It can be interpreted as being driven by supply and demand relationships, with a weighting towards supply and demand depending on one’s political inclinations. One can look at it from an entirely monetary perspective. One can look at it from a credit-cycle perspective in accordance with the Austrian school. Government deficit financing or the overall global terms of trade are also arguably the key drivers. That is just for starters.
- Taking a step back for a moment, the closest money ever got to being an abstract scale of measurement (and therefore a good base measure of ‘speed’ from which one could then measure inflationary ‘acceleration’) was the idea of ‘numeraire’ or ‘measure of value’.
- Numeraire is the lesser known cousin of the three usual definitions of money, those of store of wealth, means of exchange or payment, and system of account. That we rarely talk about numeraire these days has less to do with its exotic French name but everything to do with the fact it was an idea which was born during the era of the gold standard when there was remarkable monetary stability, and hence little inflation.
- Judging things by eye (which isn’t really that great an idea), the long-term CPI graph above shows that inflation really got going as a secular phenomenon in the early 1970s. To pick a date, that would be the 15th August 1971, the day on which President Nixon announced a temporary suspension of gold conversion under the Bretton Woods agreement. As we reach the 50th anniversary of the event, it is worth noting that inflation is so much of a permanent feature of the post-Bretton Woods system that central banks even target it as a policy goal. This was not always so.
- The graph below shows the inverse of the gold price in dollars (i.e. 1 divided by the gold price). One can clearly see the 1933 gold devaluation (from $20.67 per oz to $35 per oz), as can one see the gradual collapse in the purchasing power of the dollar in gold terms since the August 1971 gold conversion window was closed. It would seem, based on this comparison alone, that the dollar – the world’s reserve currency – is pretty much worthless, its value already inflated away.
Source: Bloomberg, as at 28th June 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.
- Such a judgement might perhaps be meaningful if we were on the gold standard, but we are not. Gold is largely not considered money these days. One could also somewhat lazily link the lurch lower in the value of the dollar in gold to political events (FDR in 1933 and his New Deal, Nixon in 1971 dealing with the exigencies of the Vietnam war and slowing domestic economic growth). That only tells a part of the story though.
- Clearly there are a number of semantic problems relating to the inflation debate which go far beyond a number going up or down every month. It would seem that the fiat money era has been inherently inflationary, yet much of the last thirty years has been characterised by disinflation. Looking at words like ‘transitory’ in that context shows that this is not an easy discussion to resolve. Is it a surprise then that the market is ignoring much of the debate?
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