Fed officials have uniformly rejected the notion that it may ultimately be impossible to restore inflation sustainably to 2% in the US.
I certainly understand why they’d dismiss the idea of adjusting their inflation target or otherwise revisiting the definition of “price stability.” Although 2% is an arbitrary target, abandoning it could undermine public confidence in monetary policy’s capacity to control inflation, and because inflation is in part a function of expectations, there’s some risk that even broaching the subject could result in a self-fulfilling prophecy.
Nevertheless, it’d be extremely foolish to rule out the possibility that at least some of the structural disinflationary enablers we took for granted over the past three decades (but which faded beginning in 2020) won’t reassert themselves in the near- to medium-term. Globalization can’t be rolled back entirely, but at the least, some companies will favor near-shoring over far-shoring and just-in-case over just-in-time until the friction introduced by the pandemic and exacerbated by the geostrategic realignments associated with the war in Ukraine, abates.
At the same time, socioeconomic trends are likely to skew inflationary, as labor continues to reclaim lost ground from capital and successive generations of voters reject inequality in all its various manifestations. Although wage growth will probably cool (an index from Indeed suggests it’ll be back to pre-pandemic levels by the second half of 2023), the US labor market may never be the same, and could be characterized by inflationary mismatches between open jobs and applicants willing or qualified to fill them in perpetuity.
I could go on. And I have. This is a discussion I revisit at regular intervals.
It could very well be that between the factors mentioned above, rolling energy and food shocks associated with war and climate change, and also what’s likely to be consistent pressure on lawmakers in developed economies to wield fiscal policy in the service of ameliorating inequality, inflation won’t return sustainably to 2%.
In a note dated December 8, BofA’s Michael Hartnett suggested the Fed may need to come to terms with that — and as early as next year. “Inflation will fall in 2023, but the big three secular themes for the 2020s are climate change, globalization to regionalization and inequality to inclusion,” he said. “All inflationary.”
Regular readers will note that this is familiar territory for Hartnett just as it is for me. He’s been over this and over it. But in his latest, he explicitly said that in 2023, the Fed “likely admits defeat on 2% CPI.”
I don’t know how “likely” that is, particularly given the pushback it’d receive from Republicans on Capitol Hill if it were made explicit, but it’s certainly possible that the Fed is compelled to implicitly give up, where that means pausing rate hikes (or even pivoting to rate cuts) before inflation is on a trajectory that’s conducive to the achievement of a return to 2% price growth.
The figure (above) shows Fed pricing by meeting. It’s current through Friday, although you wouldn’t know it — pricing is virtually unchanged from the last time I updated the visual.
The hawks among you will scoff at the idea of abandoning 2%, not because you don’t recognize it’s possible, but rather because it’s unpalatable to you. While I sympathize on some level, it’s also important to acknowledge that if Fed funds gets to, say, 5.5% or 6%, and inflation refuses to budge from, let’s just call it 4%, it’d be far from obvious that the proper course for monetary policy would be to hike rates to 6.5% or 7%. Maybe that’d make sense as a kind of last-ditch effort, but beyond that, it’d become increasingly difficult to argue that incremental hikes make sense if inflation isn’t responding, particularly if the economy is already in a recession. If the policy rate is markedly higher than inflation, and M2 growth is dropping rapidly, but price growth still isn’t down to target, there may not be any choice but to revisit the target — especially considering that, as noted above, the target was almost totally arbitrary in the first place.
So, what happens if the Fed does “admit defeat,” as Hartnett posited? Well, the dollar would weaken, he suggested, and the 15-year bull market in relative US equity outperformance versus EAFE and EM shares, would likely be over.
The figure (above) is self-explanatory. US shares have outperformed their global counterparts to an extent that makes previous instances of relative strength look wholly pedestrian.
Another argument for the end of US exceptionalism is the contention that America’s tech titans won’t manage to rekindle the kind of blockbuster growth that became synonymous with the FANG cohort and various successors (e.g., FANG+, FAANM, etc.). A falling dollar would help to the extent the FX headwind was part and parcel of decelerating revenues for big-tech this year, but it wouldn’t be sufficient to make up the difference if America’s tech champions really were just well-disguised cyclicals all along.
In any case, Hartnett’s suggestion that the Fed may concede defeat on its inflation target was notable. Again, I’d argue that any such admission would be tacit — the market would need to divine it by taking a “Don’t listen to what they say, watch what they do” approach to the Fed in 2023.
I’d add two quick points in closing. First, admitting defeat in the short-term (say, if the US economy decelerates sharply, forcing the Fed to choose between persisting in what would be pro-cyclical tightening, and leaning against the downturn at the risk of giving back progress on the inflation front) isn’t the same as scrapping the 2% target for good, forever. Second, there’s been quite a bit of discussion about how QT plays into this equation. There are technical (almost binding) constraints on balance sheet rundown. It seems likely to me that the Fed will be compelled to end QT before the onset of a US recession.
Where does the current restrictive immigration policy of the US factor into the discussion?
Nowhere, because discussing that would mean addressing the issues that actually matter in a way that might actually make a difference, which is something US lawmakers are allergic to doing.
It’s weird that Biden isn’t pushing it, though, right? Like i feel like the narrative isn’t that complicated. “Want cheaper milk? Bread? Fruit? Well let’s let a bunch of cheap labor in to harvest it for us!”
The polls say that brown people are scary and the opposition has made the debate almost entirely about brown people. Nevermind the actual stat that most undocumented migrants arrive via plane, from Asia – there is some accidental truth to the fear of brown people vis-a-vis agriculture where seasonal and physically demanding jobs often are filled by migrants from Central/South America.
Anyhow, I digress: Joe won’t exercise rhetoric when it involves people who have been thoroughly othered, especially when the sentiment is held by many of his own party members.
National health insurance would enable labor to move around the country as it sees opportunity. Short of immigration, not much else can be done.
Labor is going to continue to be more expensive and retirees are going to be more strapped.
Interesting topic.
Without thinking hard about the macro – that being beyond my ken anyway – it seems that target inflation should have some relationship to trend GDP growth, because inflation is a factor in long-term interest rates. So if real GDP growth is 2%, inflation is 2%, and nominal GDP growth is 4%, then having yield below growth should be fiscally easier to deal with that the reverse. The US had the easier situation (10Y yield < nominal GDP gro) for most of the 2000s and 2010s, versus the opposite in the 1980s and 1990s.
FRED chart https://fred.stlouisfed.org/graph/?g=XpNE (GDP growth shown is nominal.)
Put another way, low growth and high inflation sounds too much like stagflation, a word Powell and the rest of the FOMC very much don’t want associated with them in future history books.
I’d think it’d be remiss to ignore housing costs in the list of trends that will skew inflationary going forward. The housing market is broken. While prices are going down, the actual cost of ownership will continue to rise as new supply starts to dry up in the coming year and financing costs remain high. As with labor supply, the Fed raising interest rates isn’t going to resolve the underlying issue. Ultimately, their policy becomes self-defeating if they just reduce the nominal price of a house without addressing the total cost of ownership.
Fixing the things that make housing unaffordable is beyond the Fed’s purview or powers. That’s for Congress and states.
Well said. Until we address housing affordability, I don’t see how inflation can really be brought under control. And I totally agree that the 2% inflation target is toast for all practical purposes. I believe we are dealing with long-term cycles, and we are at the pivot point from 40 years of disinflation to (perhaps as much as) another 40 years of steady inflation.
Volcker-breaking-through-the-wall-like-the-kool-aid-man.jpg
Difficult, you say? Let me tell you about how this is a vital sacrifice labor must make in pursuit of our fight against the evil empire…
I have a lot of confidence that the Fed will do what is needed to bring things back into alignment. That includes pushing interest rates beyond a 6 handle. Recessions are terrible and the victims should be offered assistance but high inflation affects everyone and is very is regressive. The precedent of Volcker’s actions will make it difficult for the current Fed to exit the battle early. A lot will hinge on whether inflation gets down to the 3-4 range or becomes resurgent and moves back into the higher single digits.
One thing I wonder quite often is how many of the people who constantly reference Volcker could tell you, step by step, what unfolded over his Chairmanship off the top of their heads. I think it’s quite likely that if you said, in response to such folks, “Ok, so tell me what all Volcker did, starting from the beginning…” most people wouldn’t be able to tell you anything at all. Sure, people like Larry Summers could, but what about the scores of people who spend their days feigning nostalgia for something they know next to nothing about? If someone can’t tell the story without looking it up on Google, they shouldn’t be citing it in conversation. That goes for anything.
Obviously, I’m not referring to anyone’s comments here, I’m just saying in general — there are hundreds, if not thousands, of people, who talk about Volcker all day every day in 2022. I doubt most of them know many of the details by heart.
Trapped in the nostalgia hall of mirrors where I’m nostalgic for the Reagan years when believers were nostalgic for the cowboy era when cowboys yearned for the age of Lewis and Clark who were nostalgic for a time in St Louis where they dreamed of the Paris of long ago…. Nostalgia is best when served with a generous dose of amnesia.
Yeah, nostalgia is a helluva drug. I’m not a very nostalgic person, but I often find that when nostalgia manages to break through my heavily fortified mental defenses (which are designed specifically to keep out any sort of sentimentality), I’m nostalgic for periods that I either didn’t live through, or periods of my life that were objectively bad.
How many could even pick Paul out of a lineup? (Especially if height-adjusted),
I’d say most people could do that, my point is just that I think a lot of market observers are inclined to believe that because they’ve paid attention to developments in monetary policy over the past 10 or so years, they have all the context they need to reference Volcker. Like, “Well, I know how this works because I’ve been a keen market observer since 2010, and I have these FRED charts of EFFR and CPI, so what else do I need to know?” The answer is: A lot, actually. So much, in fact, that I’d argue the two periods aren’t even amenable to comparison unless you’re confident that you can deliver an account of concurrent monetary, fiscal, macro and political developments for that period that’s just as accurate as the story you could tell about the same developments over the past 10 years.
In other words: If you’re not just as “fluent” in the 70s/80s as you are in the 2010s/early-2020s, then it’s not clear to me why you’d feel like you’re qualified to make comparisons. Again: People like Larry Summers can make those comparisons all day long, but three-quarters of market participants (including a lot of analysts) can’t. I think that’s disqualifying when it comes to opining on Volcker and inflation.
Yes, I agree wholeheartedly. Whether it’s now or the so-called “Volcker era,” one thing we can all agree on is that there is always a lot of moving parts or even whole moving wings (as you say, monetary, fiscal, trade, political, macro) that are shifting and interacting all the time. But to mythologize a bit here, I feel like the ’87 crash brought up the endless comparisons to the ’29 crash and helped give birth to a growing obsession with analogues — i.e., last time this happened, this is what happened next — that persists to this day. More recently, I feel like AI and data scrapers have made the search for analogues self-fulfilling. No need to figure out what anything means or how everything ties together. Just hunt for the analogue and hope history repeats. And if you’re beholden to a model that starts skewing, just throw in an exogenous variable to “explain” the growing error component — it’s ZIRP or the pandemic or energy self-sufficiency or war or climate change or whatever you need it to be to fix your model, at least until the sands shift again.
I honestly think invoking Volker other than to reference prior paths for policy is largely disingenuous and unhelpful even for folks like Summers or Powell, who has done his fair share of Volker idolatry and could clearly tell us how Volker conducted policy in the 80s. It all happened 40 years ago, the equivalent of a century in modern times, the US had a completely different economy, debt situation, means of public communication, a very different political climate and a population less divided and cognizant of the massive inequalities in our system. Subjugation of inflation back then was a task that required considering dynamics very different from our current reality, invoking Volker’s strategy and action to defeat inflation today is as valid as saying that in a modern war say against China or Russia, the US should proceed with the same strategy and tactics Eisenhower deployed to win the second world war in Europe.
Volcker has become a meme, in the original sense of the word–an idea transmitted among minds as genes are transmitted among organisms. Much as Shakespeare’s quote mutated into, “Something smells rotten in Denmark,” memories of Volker’s tenure have mutated into, “Raise rates to 20% and make inflation go away.”
I might be ok with an explicit retreat from 2%. As you say, it’s an arbitrary target anyway. A tacit withdrawal while still espousing a 2% target would be tantamount to lying to the American people and to the US government. It would be an effort to avoid accountability and would merit a rethinking of the fed as an institution.
Appreciate the perspective, especially potential USD and RoW equity repercussions for covert Fed shift in target.
Excellent behind their eyes and beyond their minds comments about politicians (immigration) and Volcker.
Looking forward to more about this: “There are technical (almost binding) constraints on balance sheet rundown. It seems likely to me that the Fed will be compelled to end QT before the onset of a US recession.”
Thanks.
No one has mentioned the price of oil. If you lived thru the Volker destruction of inflation you know it coincided with the destruction of oil prices.
“There are technical (almost binding) constraints on balance sheet rundown. It seems likely to me that the Fed will be compelled to end QT before the onset of a US recession.”
I’d enjoy hearing more on this topic. People are paying so much less attention–as measured in CNBC headline click bait–to QT than to rates. I recall someone (Panigirtzoglou?) mathing that every $100b of QT was roughly = to 0.12% of rate hikes. Meanwhile, there’s incredible obsession with where terminal rate will hit with no discussion of when QT taper will begin.
I think QT (just like QE) has more effects with financial asset price than main street economy and inflations, that is until the wealth effect or the reverse of it spill over to main street. So far I didn’t see QT has much impact to the long rate.