This Is Not A Drill

This is not a drill.

That’s the message emanating from economists, policymakers and analysts who, on a delay, are coming to terms with the idea that developed economies are perilously close to a tipping point, beyond which inflation becomes a self-fulfilling prophecy.

In a note updating their Fed call, JPMorgan described a “feedback loop” in which growth, higher costs and consumer psychology may interact to drive inflation on a more structural basis. The bank “no longer see[s] deceleration from last quarter’s near-record pace,” Bruce Kasman said, on the way to warning that central banks may now feel compelled to engineer a slowdown. The bank called that “the most significant threat to an otherwise healthy global backdrop.”

On Friday, Charles Evans called Fed policy “wrong-footed.” Prior to 2022, officials were very reluctant to countenance the idea that the Committee was behind the curve — or at least publicly. Now, public admissions to that effect are becoming ubiquitous. Although he continues to view inflation as largely a function of “unusual supply-side developments related to the COVID-19 shock,” Evans nevertheless cautioned that “inflation pressures clearly have widened in the broader economy,” a development which demands a “substantial” shift in the Fed’s policy stance.

Evans stopped short of endorsing the view that the Committee may need to hike rates into restrictive territory. Earlier this week, at an event hosted by Columbia University and SGH Macro Advisers, Jim Bullard mused that “if you wanted to put downward pressure on inflation, you’d actually have to get to neutral — go beyond neutral.” “That’s a major concern of mine,” he remarked. “We’re not really in a position to do that right now, but we have to get in a position to do that.”

Notably, expectations in the latest vintage of the New York Fed’s consumer survey dropped, and dramatically across some demographic cohorts. Median year-ahead expectations fell for the first time since October of 2020 and three-year expectations fell sharply (figure below).

The drop in the three-year gauge reflected declines across age, education and income groups. It was the biggest one-month drop in the survey’s (admittedly short) history.

Unfortunately, I’m compelled to suggest that the ratio of noise to signal in the NY Fed’s survey may be increasing. The poll includes data on the 75th and 25th percentiles, which allows one to calculate the scope of inflation uncertainty, but from a purely anecdotal perspective, there are some glaring anomalies that cast considerable doubt on the usefulness of the data. For example, median three-year expectations among the “some college” cohort almost never moved from 3% in the half-decade from October 2014 to March 2019. From Q1 2019 through January of 2021, they tended to drift in a range between 2.5% and 3%. Then they took off, hitting an eye-watering 5.3% in October of 2021, only to plunge by nearly two full percentage points over the ensuing three months. With apologies to the economists at the NY Fed, it’s not possible to divine much from that.

Fed officials are fond of pointing to still-anchored medium-term expectations when it comes to defending themselves against accusations that policy is now so far behind the curve that catching up may not be possible. But to the extent market participants are better off observing what policymakers do (or plan to do) than listening to what they say, the juxtaposition between officials’ increasingly urgent rhetoric (and attendant plans to tighten policy) and their steadfast insistence on the idea that long-term expectations aren’t at risk of becoming unmoored, is notable.

Markets now clearly believe the odds of policy panic are elevated. The latest installment of BofA’s Global Fund Manager survey showed investors believe monetary risk is the greatest risk to financial stability (figure on the left, below).

That’s consistent with JPMorgan’s contention that “the risk that central banks shift and perceive a need to generate slow growth” now represents the “most significant threat” to the global macro outlook.

During the same remarks mentioned above, Bullard this week said the Fed has to “manage the risk that [inflation] doesn’t dissipate, as some people might hope.” The market, Bullard warned, is “losing faith to some degree that it’s going to dissipate in any reasonable amount of time.”

JPMorgan now sees the Fed hiking 25bps for the next nine straight meetings.

Again: This is not a drill.