Nearly every media article about Fed policy and US inflation is a contradiction.
Commentators and pundits of all sorts seem oddly oblivious to the cognitive dissonance inherent in describing aggressive tightening as something that “should” happen, only to say, in the very next sentence (and sometimes in the same breath) that such a pivot risks a policy mistake.
So, effectively, the message to the Fed is that they should commit a policy error. Small wonder officials are predisposed to being aloof and otherwise disengaged from the daily cacophony.
Of course, the Fed was wrong to call inflation “transitory.” Or, more accurately, if “transitory” meant something different to them than it means to the folks who compile dictionaries, they should have found another word.
But the key is this: If the message to the Fed is about what they need to do, as opposed to what they should do, then we should just say that. We should demonstrate the same commitment to linguistic precision that we expect of policymakers.
Clearly, the Fed shouldn’t commit a policy error. But it’s eminently possible that the Fed needs to take that risk if it means short-circuiting the expectations channel before consumers’ views on prices become unmoored.
It’s too late to keep realized inflation from becoming temporarily unanchored. That ship has sailed. Headline CPI ran at 6.8% on a 12-month basis in November. That’s not even consistent with price stability in an emerging market. But longer-term expectations are still reasonably anchored (figure below).
Far be it from me to adopt a sanguine view, but if the expectations channel is the only thing the Fed can reasonably hope to affect with monetary policy (rate hikes won’t solve most of the problems pushing up prices in the post-COVID environment), there’s still time to act preemptively.
That distinction is important. You can’t “preempt” something that’s already happened. Pundits suggesting the Fed “get a handle” on inflation are asking the Committee to time travel. And even if Jerome Powell was a regular Marty McFly, it wouldn’t matter, because rate hikes would be equally impotent when it comes to solving supply chain disruptions early last year as they’ll prove to be now. But the Fed can act preemptively to keep longer run expectations from coming unglued.
During an interview with CBS’s “Face the Nation” on Sunday, Mohamed El-Erian got it mostly right, although his remarks still came across as yelling fire in a crowded theater.
“The characterization of inflation [as] transitory is probably the worst inflation call in the history of the Federal Reserve,” he told Margaret Brennan, adding that,
It results in a high probability of a policy mistake. So, the Fed must quickly, starting this week, regain control of the inflation narrative and regain its own credibility. Otherwise, it will become a driver of higher inflation expectations that feed onto themselves. If you hit the brake hard in a few months, there’s a risk you send this economy into recession, and it would [do] unnecessary harm to livelihoods. What they need to do now is ease their foot off the accelerator. There is no reason why they should be injecting so much liquidity. There is no reason why they should be boosting the housing market at a time when house prices are pricing Americans out of buying homes. They should ease their foot off the accelerator in order to avoid slamming on the brakes later on.
Again, that’s all generally correct. One problem, though, is that El-Erian (like Larry Summers and a handful of other “brand names”) seems unaware of the extent to which Americans are far more likely to adjust their inflation expectations in response to dire-sounding warnings delivered on national television by people with impressive CVs, than they are to the perception that the word “transitory” has worn out its welcome in FOMC statements.
That’s not, of course, to say that everyone should sweep the issue under the rug when consumers are paying more for virtually all of the things they need. It’s just to say that those price increases are predominately the result of issues the Fed doesn’t control. And, in all likelihood, they will dissipate over time, even if “transitory” is the wrong word to convey that to the public.
If it’s expectations we’re worried about, El-Erian is correct to suggest the Fed can have an impact. But when he tells CBS that this Fed just made “the worst inflation call in history,” some consumers will internalize that message and incorporate it into their own expectations. It’s just gasoline on the fire.
Asked when the Fed should start thinking about raising rates, El-Erian said “we should be starting to talk about that now.” He told Brennan that,
It’s important to stop inflation being embedded into the system because two things happen when inflation gets embedded. One, you lose purchasing power, and the poor suffer the most. Second, you get a Fed overreaction and then you get a recession and then you get income losses. So, you really want to navigate this process in a timely and orderly way.
One more time: That’s all true. The problem (and rates traders seem to understand this quite well), is that it’s the furthest thing from clear that any Fed action will be effective enough on the inflation side to offset any damage done by tightening policy into a waning fiscal impulse and against a backdrop where uncertainty about the pandemic is still very high.
The talking point about “slamming on the brakes” suffers from being too nebulous. What counts as “slamming on the brakes”? Is it realistic to suggest that headline CPI could be running 15% in six months, forcing the Fed to hike 400bps in one meeting? That would certainly count as “slamming on the brakes.” But it’s so far-fetched as to be mostly useless as a thought experiment. It’s not obvious (to me anyway), that staying patient runs the risk of an inflation overshoot so severe as to warrant policy action that would unequivocally meet anyone’s definition of brake-slamming.
Frankly, there’s an argument to be made that the Fed should just announce an immediate end to MBS purchases (it’s painfully obvious that those are now doing more harm than good) and take no additional action at all until there’s a data-driven case for doing something. If everyone is being honest (which they never are), the case is still far stronger for an abatement of inflation than for an ongoing, upward spiral.
Here’s the key takeaway: It’s true that virtually all of us suffer from recency bias when it comes to assessing the risk of persistently high inflation in developed economies. But it’s possible (and perhaps likely) that we’ve become so concerned about recency bias that we’re now overcorrecting for it.
I absolutely agree that halting MBS purchases is not only prudent but would halt another epic housing bubble in the making. With housing prices where they are currently, I doubt the investment made in these MBS’ will actually end up getting paid back, instead we’ll see massive defaults.
It’s ironic to me that the only bad inflation anymore seems to be CPI inflation. When markets are inflating like crazy everyone, Fed in included, seems to think that’s somehow good inflation. Does it matter that being a millionaire is no longer even the bar for middle class retirement? I guess not. The hottest housing market ever the past 18 months also wasn’t counted as bad inflation. Even though we’ve already seen systemic market spillover from a housing bubble failure in the very recent past. And as it was pointed out earlier, secondary education inflation has been running rampant for decades. My parents were able to go to college working a part time job with no student debt. I had to borrow some money to go to college but nothing extreme. The Covid generation will have to borrow a home’s worth of money for their education.
I think while it’s important to worry about a future Fed policy mistake, what we’re ignoring is that where we are right now is because of existing Fed policy mistakes. Those mistakes are already baked in now and just because the Fed has to respond to inflation doesn’t mean those policy decisions are mistakes, instead they are going to reveal the policy mistakes of ignoring inflation that should have been raising alarm bells a while ago.
When inflation gets bad enough to have a negative impact on both small and large corporate sales and profits ( due to slowing demand), human ingenuity will figure out how to produce a lower priced model ( Ford Maverick) and reduce cost structure ( automation) to drive sales and profits. This will be way more effective at dealing with inflation than any CB actions.
Cool, when will that be and what happens to American purchasing power in the meantime?
Also do these non fed mechanisms apply to housing?
I’m seeing it on the financial media, financial message boards, and the local news. Inflation hysteria has taken hold. With the views generally lacking context nor any depth of understanding, including the “experts” who have rendered themselves as reactionary propaganda puppets (El-Erian, Summers) for the investor class.
As well as being weaponized by the GOP as a reason to oppose social spending and boost their 2022 election chances.
I think the complaint on a policy error is more that the Fed could have started much earlier in easing back on accommodation. Thus, the error is that they artificially get demand super high and now have to deal with the issue of how to slow demand enough to allow supply chains to catch up
If the group of American people most negatively impacted by inflation spend almost all of their money on food, rent and interest payments on student debt and/or credit card interest- call me skeptical- but I am not convinced that the Fed curbing bond buying and minimally raising short term rates 2-3 times in 2022 is going to significantly help that large subset of Americans.
Short term (2022) fed action may not help “significantly” but it might help at the margins. Reducing speculation in many assets, commodities included, can help to ease some producer costs. Reducing the prevalence of ‘buy now pay later’ programs can also delay/destroy some demand. Slowing the growth (or possibly shrinking) the price of housing is also helpful.
We can argue about what “significant” means.
Many act as though the fed has a mandate to support markets instead of supporting price stability.
If the fed “can’t do anything” about inflation they need a new stated purpose for existence. One that might not be as popular amount the masses.
The Fed is also charged with helping employment and providing for a stable banking system.
I would argue that the Fed shouldn’t even care about the market. The market in bubble finance is actually bad for the banking system.
when the fed thinks it might not be up to those tasks it quickly seeks emergency powers to ensure it is. It doesn’t say “nothing I can do about it”
The inflation narrative has been a mainstream media narrative for a while now and is clearly now a political narrative heading into next year’s mid terms. That said, if the past 6 months has told us anything, it’s to ignore such narratives when it comes to investing, given some of the s best performing exposures since the narrative went mainstream have been disinflationary beneficiaries like the US dollar index, long duration Treasuries, and high quality/profitable growth names. In contrast, supposed inflationary beneficiaries like precious metals and EM (both equities and FX) have fared poorly.
The only data point that matters anymore is the Fed. Inflation sucks and it’s going to impact the people who don’t invest anything more than anyone else. But the market is purely Fed driven. If they continue with tightening it will dip. Welcome to Japan.
Given El-Erian’s recent statement he is now entering the same category for me as Larry Summers- aging prize fighter- he used to be good. Powell is not infallible certainly. But at least he admits mistakes and adjusts. I want to see El-Erian and Summers admit they were dead wrong if inflation and the economy slow down in 2022s second half. I would bet they won’t utter a peep. The Fed may have been a few months late tapering. Everyone is whining about the Fed. Nobody has or had a crystal ball- and guess what we are still in the middle of a horrible pandemic. So lets see. They let the economy bounce back, and in doing so combined with the reopening from a dead stop shock inflation took off. Guess what? The FOMC has been trapped at the zero bound. If the boo birds are right there is a straight forward solution. End Q/E quickly and then if necessary raise rates. If the FOMC raised rates and got to a 1.5% target in 18 months that would be the opposite of terrible. At least we are off the zero bound. Isn’t that what everybody wanted? What would Larry or Mohammed do if the economy rolled over with monetary policy? Oh yeah crickets. Too- look at what other developed markets are experiencing. The ECB had less fiscal/monetary stimulus. Guess what? They also have pretty high inflation too. And the US yield curve is in a bull flattener recently. Does that suggest the Fed is too late? If they were, we would be seeing a bear steepener of the curve. Probably 2/3 of the current inflation problem is a supply side problem- monetary policy has no answer for that problem. So, put me in the camp that El-Erian and Summers are full of sh-t and are coasting off their prior reputations. I think they are dead wrong, and arrogant to boot, and I hope Powell and the FOMC ignore them.
Well put!!
Inflation is a supply side problem exacerbated by lower dollar costs. Would housing be doing what it is currently doing without the Fed buying up MBS’? I highly doubt it. Would the markets still be going up with 11M open jobs and a new Covid variant without the Fed easing? Doubtful, before Fed easing we had a 1 month recession. Again, CPI is the only inflation that’s bad anymore? The data was there in May that inflation was here to stay based on supply chain issues from 2020 finally catching up and continuing impacts of new Covid slowdowns and the energy crisis in China. That should have at least started the tapering discussion, if they had been paying attention.
Bravo. Thank you for your articulate and spot on comment!
Why was the purchase of MBS ever included in the QE program?