The Fed’s messaging is changing
It is hard to overemphasize the importance of Jay Powell’s remarks at the BIS-SARB panel discussion where he notes the Fed’s new policy framework may not be well suited to current conditions.
“Our framework if you go back and look at it what it was designed to do was the case where labor markets got tighter and tighter and inflation didn’t react. That’s the situation we had for a number of cycles, particularly the last one. This is a very different situation. The situation now of course is we are still 5 million jobs below the level of February 2020 so we are not at maximum employment, at the same time inflation is not moderately but well above target. So it is not the situation where that sort of patient approach was specifically and clearly designed for. This is a different situation. This is a situation in which the two side of our mandate are in tension…
“Getting to your point about being late: employment still 5 million below where it was pre-pandemic, if you say well how far is it below trend job creation its actually 7 million-plus. Nonetheless the labor market is very tight by many measures. That’s partly because its taking time for workers to find new jobs and partly because many people are still holding off work for now due to Covid. So while the time is near now for tapering asset purchases, it would be premature to tighten policy by actually raising rates with the effect and intent of slowing job growth when there is good reason to expect a return to robust job growth and for these supply constraints to diminish…the risks are clearly — now — to longer and more persistent bottlenecks and thus to higher inflation. We know we see higher inflation and the bottlenecks lasting well into next year…I would say our policy is well positioned to manage the range of possible outcomes. I do think its time to taper, and I don’t think it is time to raise rates…so again we need to watch and watch carefully to see if the economy is evolving consistently with our expectations and adapt our policy accordingly” - Jay Powell at the BIS - South African Reserve Bank Discussion, 22 October 2021.
Meanwhile, a recently released paper from a researcher at the Federal Reserve adds academic weight to this doubt over the framework.
“…an important policy implication would be that it is far more useful to ensure that inflation remains off of people’s radar screens than it would be to attempt to “re-anchor” expected inflation at some level that policymakers viewed as being more consistent with their stated inflation goal. In particular, a policy of engineering a rate of price inflation that is high relative to recent experience in order to effect an increase in trend inflation would seem to run the risk of being both dangerous and counterproductive inasmuch as it might increase the probability that people would start to pay more attention to inflation and—if successful—would lead to a period where trend inflation once again began to respond to changes in economic conditions”
It is pretty well established that inflation is a macroeconomic variable which exhibits high serial correlation — observations of the past values tend to be predictive of later values. Economist Charles Goodhart made a related point in his address to the ECB at Sintra (slides below) where inflation expectations are less predictive, but are rather informed by an average of past inflation readings. Paul Tudor Jones discussed this phenomenon in a recent CNBC interview as well.
A cursory view of the implications of this for portfolio construction is that if inflationary readings are unlikely to recede very much (consistent with our prior observations), the Fed will ultimately need to reassess its stance and this will likely manifest itself in an increase in real yields. In my view, this poses a very significant risk for segments which have historically benefitted most from multiple expansion, namely technology.
