No, I haven’t gone schizo. A few days ago I wrote It’s Not About The Fed, in reference to the selloff that had gripped the financial markets, to counter a Wall Street narrative pinning it on a sudden realization the Fed would hold rates higher for longer, apparently to charge the Fed for the incredible demand fiscal deficits were placing on markets for finite capital.
I’ve also written on numerous occasions that we as investors are better off focusing on the Treasury yield curve, not media noise about the Fed, for guidance in structuring our investments. None of this has changed.
But Fed watching as a pastime hasn’t either. And there’s at least one area in which Fed policy has a profound impact on our collective futures.
What prompts this latest commentary is that the volume knob has been ratcheting up on an already pervasive stream of Wall Street cries for the Fed to abandon the 2% “inflation” target that it has articulated since Ben Bernanke’s chairmanship. I put “inflation” in quotes because it in fact refers not to inflation per se but to the annual rate of increase in the Personal Consumption Index (PCE) deflator. Especially the so-called “core” version excluding such nonessentials as food and energy, and even extending to a more fancifully monikered “supercore” version adding shelter to the list of luxuries to be excluded. PCE differs in technical detail but is nevertheless not unlike the CPI in that it tracks US domestic consumption prices. Both are, more accurately, cost of living indexes.
The 2% figure was pulled out of thin air to begin with, so we might be excused for being unruffled by a change. It was apparently motivated by a sort of slippery slope theory that holds that deflation is caused by inflation slipping too low. Never mind our last real world experience where deflation emerged straight out of the bowels of an inflation panic associated with $147 a barrel oil in mid-2008.
The justification for the amped up Wall Street wailing is nominally that the 2% target is too restrictive, that it might result in a “hard landing” for “the economy”. The demand for labor might soften.
That this would purportedly be the concern du jour seems a little more than disingenuous to your correspondent. The front page economic story for the better part of three years has been high inflation, decorated with a ceaseless narrative of an excessive demand for labor relative to supply and an unemployment rate running at multi-decade lows. Employers complaining of worker shortages. If there is any problem in need of fixing, it doesn’t appear to be overly soft labor demand or insufficient inflation.
Not so widely trumpeted is the effect the Fed’s tightening campaign had on Wall Street last year. We remember. The New York Times reported in December that For Many Wall Street Bankers, This Year’s Bonus Season Is a Bust. Investopedia reported in March Wall Street Bonuses Fall 26% to Pre-Pandemic Levels, leaving the average bonus at merely 2.5 times the median American family’s entire annual income.
What we don’t hear as much about from Wall Street is how inflation is hammering the living standards of millions of ordinary Americans. But J Powell has cited it in every post-FOMC press conference since embarking on this tightening campaign, perhaps underscoring his resistance to Wall Street’s demands the Fed back off.
So the Fed’s “inflation” target matters more than it may appear. An increase would signal a shift in the Fed’s stated allegiance from Main Street to Wall Street; as a creature of the latter, the pressure is intense. Not that it would be explained that way, but the signaling value would be profound. If it can go from 2% to 3%, why not from 3% to 4%? And from there to … where?
It would kneecap the Fed’s credibility, potentially resulting in even more restrictive concrete policy being required to achieve the same result. Yet higher interest rates as markets price still higher inflation into yields. It might even crimp the fire hose that has been showering Wall Street with lucre. No question though middle America would be in for even more pain.
There never should have been a 2% target to begin with. But once established, the risk in raising it raises a Pandora’s Box of consequences. Future America could even find itself in a similar struggle as today’s Argentina.
i’ve been thinking about how [not when] the fed will cave.
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1. it is inevitable that the fed will cave. the 8% of gdp deficit [during a time of record low unemployment] pours excessive federal spending into the economy, while producing a deluge of treasury paper [borrowings].
………..foreign cb’s ceased buying years ago, and there are indications that one friendly major [former] buyer, japan, has been selling as japanese rates creep upward, the cost of hedging a yen-based investment in u.s. treasuries soars, and there may even be some official selling in an attempt to stabilize the plunging japanese currency.
………..u.s. banks are already full of [underwater] treasury paper [witness what happened at svb]
………..i expect more financial repression. money market funds, insurance companies, and pension plans [including your ira or 401k] will be mandated to hold a certain percentage of treasuries or new annuity-style treasury paper, “for your own good.”
…………even these measures will be inadequate to soak up the treasury deluge.
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2. the fed will be the buyer of last resort, reversing its qt program, just as the btfp implemented reversed 4 months of qt after the svb etc failures.
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3. the deficit spending plus a tight labor market and rising inflationary expectations will continue to deliver “inflation” numbers above the fed’s target.
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4. it will be very hard for the fed to concede to the calls for a higher target. it’s not just the loss of face, it’s that such a concession will encourage prices to rise even faster.
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5. conceding on qt does not mean conceding on interest rates. [although it might- see ycc below] the fed can keep raising rates. the coming waves of corporate debt refinancings, especially related to commercial real estate, will keep both business and personal bankruptcies high. Note:
…….”Business filings rose 23.3 percent, from 12,748 to 15,724 in the year ending June 30, 2023. Non-business bankruptcy filings rose 9.5 percent to 403,000, compared with 367,886 in the previous year. Bankruptcy totals for the previous 12 months are reported four times annually.”
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6. we’ve seen tight monetary policy coupled with loose fiscal policies before. the reagan tax cuts combined with the volcker rate hikes embodied this. the result was a soaring u.s. dollar. “the dollar wrecking ball,” as it’s been called recently, created havoc around the world. [e.g. will china keep allowing the yuan to sink, raising it’s import prices while helping its exports? or will it counter that pressure by selling dollar assets including treasury paper, hurting its exports?]
……loose fiscal plus tight monetary led, eventually to the plaza accord in 1985, when everyone agreed to guide the dollar down. note that the rise in the dollar did not cause the price of oil to go down- it rose. otoh, gold fell from its 1980 high. the main outcome, though, was the rise in the dollar.
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7. the alternate course for the fed is to implement yield curve control [ycc], fixing the prices of bonds by offering to buy any treasury bond offering a rate higher than its peg. note that this, too, reverses qt, but it does not impose a tight monetary policy. it’s hard to imagine the dollar maintaining, let alone increasing, its value relative to other currencies under this scenario. this scenario imo has to be good for gold. but i think this scenario is less likely than the tight monetary policy outlined above.
I don’t dispute whether the Fed will eventually cave on accommodation in general. I’m specifically concerned here with the “inflation” target, on which it looks like we agree. For caving on that, the gist is that it will be a dark day if it does.
Interest rate versus quantitative policy isn’t at issue here either. As you know I’ve written for years the Fed should focus less on rates and more on quantitative policy, even advocated using a more expansionary quantitative policy to facilitate interest rate normalization. Better late than never, it’s finally taken my advice.
The real problem is that to go that last mile on consumer inflation, stock prices have to go down. The resistance from Wall Street is enormous. The Fed is largely a creature of Wall Street. Its Washington charge is a little different. Its job is to save the bond market, mostly from fiscal excesses. At the risk of oversimplification, the original deal was politicians would cede to the banking system the issue of the currency, in exchange for the system serving as a bottomless piggy bank for politicians.
When things get rocky for the bond market, the Fed is walking on eggshells. Powell’s refusal to even open a crack in the inflation target door today likely reflects that he has the bond market firmly in mind. Cracking would have kneecapped the Fed’s credibility and panicked an already jittery bond market. That would have brought the nuclear option forward to now, something the Fed doesn’t want to do.
More broadly, even in the longer term accommodation isn’t a one way street. The real question is how far does it go. There is a point at which public suffering from inflation raises the political imperative high enough that change becomes politically plausible, even necessary. We saw this happen in the seventies in America. We’re seeing the Japanese central bank beginning to try and extricate itself from reckless debt monetization. We’re even seeing it in inflation-ravaged Argentina, with the emergence of a popular candidate going so far as to promise to close the central bank.
One thing we can be sure of is that no matter the formalities, the Fed’s prime objective is its own survival.
This view on the Fed’s “inflation target” has garnered support from the Bloomberg editorial board:
Despite Political Pressure, the Fed Should Hold Firm
“… This possibility is partly why the 2% target is being questioned. Would it really be worth a recession to cut inflation from 3% to 2%? The short answer is yes. Otherwise, when the economy next encounters such difficulties, the Fed will be asked whether it makes sense to get inflation back down to 3% from 4% … and so on. Remember that progress on inflation to this point is partly thanks to the Fed’s success in anchoring expectations. Deviating from the 2% commitment would discard one of its most powerful instruments…”
Yet I would still rather it were based on nominal per capita GDP.