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My Views on Kevin Warsh as Fed Chairman
I promised last week that I would give you my views about Kevin Warsh. I did so while clearly forgetting that I already have. Having heard more from him, though, I can put more meat on that bone.
I must first tell you that I have a natural tendency to want to believe that our monetary policy institutions can be saved, and so I want to believe that each new Chairperson has a chance. I was optimistic, for example, about Powell (and to be fair he was a definite improvement over Bernanke and Yellen!) even though in the end he turned out to be a fairly normal Fed Chair. I do give him credit for responding to the COVID spike a lot faster and further than I thought he would, especially since he claimed to believe the inflation was transitory. He didn’t do it right, but at least he wanted to.
My hopes, though, have generally proved to be unrequited. In my opinion, the Fed has been in a downward spiral since 1987 when Alan Greenspan took over. I once wrote a book called Maestro, My Ass! and I do not apologize for it. Although we look wistfully on the Greenspan days now, he started several trends in central banking that have been very destructive – the main one being his mission to make the institution’s deliberations and thought process very transparent. But at least he viewed inflation as the primary policy target.
This introduction is meant to point out that while I really want to believe that monetary policymakers eventually learn lessons and course-correct to doing things the right way, I’m no apologist for the Fed. You’ll want to remember this when my enthusiasm for Kevin Warsh comes out, below. Here is my framework – my basic views, expressed ad nauseum on this blog over the years, about central banking and the conduct of monetary policy:
- Monetary policy is best conducted with as little transparency as possible. It is not the Fed’s job to make the water always warm and inviting for investors so that they can lever up their returns without fear. Transparency breeds complacency and causes excess leverage in markets. As I said in ‘Maestro’: make people dig their own foxholes, and they will dig them deep enough.
- The Fed has a truly terrible forecasting record when it comes to inflation, especially. I do have to say that there are some signs of improvement on that score, so maybe the reason it has been so bad for so long is that for 25 years there was nothing to forecast since inflation was fairly low and fairly stable; now that it’s worth researching, maybe they’re learning. Some. But the fact remains that the forecasts are not even remotely good enough to base monetary policy on.
- Because economic data has huge error bars, and gets revised a lot, and forecasts have even larger error bars, it is nearly impossible to reject the null hypothesis that ‘nothing has changed’ with any given data point. It takes a long time and a lot of data to truly overcome the confidence hurdle. Since monetary policy is such an overpowering tool, it generally should be used very sparingly. The Fed should only rarely move rates away from neutral, and only when the cause to do so is undeniable. Yes, this means they will be late. But that’s okay – see point #1 – if people know that they can’t rely on the central bank to save them.
- One of the wisest things Greenspan ever said was that with respect to the dual mandate of price stability and long-term economic growth, the condition of “low and stable inflation” is the environment most apt to produce high long-term economic growth. In other words, the inflation-fighting mandate is primary, and the economic growth goal is secondary – and best achieved by means of achieving the first goal.
- Interest rates have no identifiable causal (lead) effect on inflation.
- Inflation expectations are a result of, not the cause of, inflation.
- The stock of money per unit of GDP is pretty much the only thing that matters for the price level in the long term. (Here is an article with a few of my favorite charts.)
- The implication of 4, 5, 6, and 7 is that the Fed should focus almost exclusively on maintaining money growth at a low, steady pace. This job is hard enough with the proliferation of alternate forms of money!
Now, let’s compare this to what Hopefully-Future-Chairman Warsh said in his confirmation testimony last week.
- Inflation is primary: “Congress tasked the Fed with the mission to ensure price stability, without excuse or equivocation, argument or anguish. Inflation is a choice, and the Fed must take responsibility for it.”
- The Fed should reduce forward guidance. I personally would say eliminate. I’m not entirely clear if Warsh’s desire to reduce forward guidance is because he doesn’t believe the Fed is good enough at forecasting to provide good guidance, because he thinks that too much transparency leads to overleveraged personal, corporate, and financial balance sheets, or because he doesn’t think that the Fed gains anything by trying to restrain inflation expectations. It doesn’t really matter. All three reasons are good. Any one of them is sufficient. If Warsh wants to reduce forward guidance, he’s on the right track.
- He thinks the FOMC should meet less frequently! I love that – again, I’m not sure if his instinct to do it is because he doesn’t think the Fed should be so active, or because he doesn’t think the data changes enough in a month and a half between meetings, or because he wants to be less transparent. Again, all three reasons are good.
- Warsh seems to be a believer in the notion that the rise of AI will pressure inflation downward. I do not share this view (see my article here and by podcast here), although I am a wild fan about Claude. I may be wrong. Warsh may be wrong. The important point here is that Warsh seems willing to wait for evidence, rather than conducting policy as if the Fed’s models about what could happen was in fact evidence. This is wisdom. I am absolutely content to be optimistic about the effect of AI right along with Warsh… as long as we don’t adjust policy on the basis of a guess.
- In general, Warsh seems to believe that the Fed should be less-active with respect to interest rates; he has also expressed an opinion that the Fed’s balance sheet should be smaller and is a general skeptic about relying on the balance sheet to adjust monetary policy. Unlike many at the Fed, he thinks the size of the balance sheet is related to the level of inflation and interest rates. He is absolutely correct about this and it may be fair to say that this is one of monetarists’ core objections to how monetary policy has been conducted since Bernanke. Warsh dissented on QE and LSAP (large-scale asset purchases) back during the Bernanke days. Shrink the balance sheet, and that will let you lower interest rates a little bit as inflation recedes. Absolutely. When the Fed shrinks its balance sheet – which was first expanded in an effort to stave off deflation; remember Bernanke’s helicopters? – it will reduce upward pressure on money growth and that will directly slacken upward pressure on inflation.
I don’t know if Warsh can pull off such a monumental pivot. Institutions resist change, and the Federal Reserve is a big institution. But it is a pivot worth making! If Warsh succeeds (and if I’ve correctly laid out his views), it will restore the Fed to at least its mid-1980s glory. Well, maybe “glory” is a bit strong…but this is one case in which going backwards would be a drastic improvement.
Changing the Fed’s Target – FAIT non-accompli?
As the steadier measures of inflation (core, median, or sticky depending on your preferences) have started to overshoot expectations slightly – the y/y measures continue to decline, but slower than expected as the m/m numbers have surprised on the high side – the markets have continued to price Fed policy becoming increasingly easier over the course of 2024 and into 2025. While Fed officials continue to push back gently on this assumption, it seems that most of the FOMC is comfortable with the idea that there will be at least some decrease in overnight rates later in the year and the only question is how much.
While inflation has not been settling gently back to target, there have developed two big holes in the narrative that the Fed was depending on. First, there is no reason to think that rent of shelter is going to cross over into deflation, either in 2024 or any time in the future. The belief that the CPI for rents would follow the high-frequency data into deflation was never well-founded, despite some fancy-looking papers that claimed you could get three pounds of fertilizer out of a one-pound bag if you just squeezed it the right way (I discussed “Disentangling Rent Index Differences: Data, Methods, and Scope”, and why it wasn’t going to tell us anything we didn’t already know, in my podcast last July entitled “Inflation Folk Remedies”), and while rents are declining they are not plunging, and home prices themselves have turned back higher and are growing faster than inflation again.
Second, core-services-ex-rents (so-called ‘supercore’) inflation needed to see wages decelerate a lot in order for that piece to get back towards target. They haven’t, and it hasn’t.
This isn’t to say that these things may not eventually happen, but so far the expectation that we would get back to target sustainably by the middle of 2024 looks quite unlikely. Why, then, are people talking about when the first eases will happen? The only way that it makes sense to do so is if the goal to get inflation back to 2% sustainably is no longer driving policy.
This has led to some observers pointing out that the Fed doesn’t actually have a 2% target any longer. In 2019, the Fed moved to Flexible Average Inflation Targeting, or FAIT. Under this rubric, the Fed doesn’t need to regard 2% (or about 2.25% on CPI) as a target that they need to hit at a moment in time but only as an average over some period of time. This obviates the need for overly-aggressive monetary policy in either direction, such as the instantaneous adjustment linked directly to the inflation-miss that is required by the Taylor Rule.
Unfortunately, under that rule the Fed has little if any chance of meeting its mandate. It would have a better chance of hitting 2% in…um…let’s say a ‘transitory’ way, as rental inflation swings lower and we pass close to the target briefly before inflation goes back up to its new equilibrium level. Back in August 2021 I noted that the Fed was already above the FAIT projected from the announcement of that policy, and in fact had used up all of the post-GFC slack. Obviously, it has gotten worse since then. Below, I update the two charts from that article. The first chart shows the CPI from August 2019, along with the average-inflation-targeting line and the forwards suggested by the CPI swap market (showing where inflation futures would be trading, if they were trading).
The second chart shows the CPI back to January 2013. We’ve made up all of the inflation from the post-GFC deflation scare, and then some.
Note that the inflation swap market is not indicating any expectation that prices will return back to the trendline. The market is acting as if the Fed is still operating under the old rules, where the goal was to get inflation to be stable at 2% from here, wherever “here” is. This means one of four things will have to happen, or it implies a fifth thing.
- The Fed needs to re-base its FAIT to start from the current price level. In that case, the red CPI-plus-2.25% line will shift abruptly upward but then will parallel the inflation implied by the inflation market; or
- The Fed can keep the original base, but concede that the actual target now is 3% (about 3.25% on CPI), which means that if the inflation market is right then it should be back on target by late 2029 (see chart); or
- The Fed can dedicate itself to fighting inflation for much longer, and publicly disavow the notion of reducing interest rates in the next few years. If CPI went completely flat then the Fed would be back on the line by sometime in 2028.
- The Fed can abandon FAIT, because it has become inconvenient, and validate the inflation market’s assessment that the Committee would be happy with 2% from here, not on average.
If none of these things happens, and the Fed then implies that the inflation market is going to permanently imply something different from what the Fed claims to be its modus operandi. In that case, it would be very hard to argue that the central bank had not lost credibility, wouldn’t it?
Four Quick Thoughts on Fed Day
Four fairly quick observations on this Federal Reserve meeting day, not all of which have anything to do with the Fed:
1. The FOMC today announced unchanged policy for now on the overnight interest rate, on the pace of QT runoff, and on the collective expectation of the Committee for the number of rate-cuts in 2024 (three, 25bp cuts). But it beats noting that while three cuts is the median expectation, the mean expectation dropped substantially. Only one official sees four rate cuts in 2024, compared to five who saw that many or more, as of the December survey. Those four folks moved to ‘three’, and one of the ‘three’ folks moved to ‘just one.’ Nine of the nineteen dots are for fewer than three cuts this year, so we should say this is a closer call than the market seems to think.
2. The longer dot plots also show some increase in Committee members’ expectations for the neutral short-term interest rate (the so-called ‘r-star’ originally popularized, I think, by Greenspan). The significance of this for investors and traders is that the overnight rate is unlikely to go back to zero unless we get another enormous calamity; the significance for the economy is essentially nil since it is money, and not interest rates, that matter. I’ve written before about why there are good reasons to think of something like 2-2.25% as the neutral long-run real rate, and so if CPI inflation is expected to be 2.25%-2.5% then something around 4.5% is neutral long-run nominal rate. We are mighty close to that now, so there is no compelling reason to think that interest rates should decline markedly from here. At the short end of the curve, we should eventually be lower – but we need to also keep in mind the growing imbalance in the supply and demand for Treasury paper, which (in the absence of recession) will tend to keep rates on government paper higher than they otherwise would be in equilibrium – and as one consequence, by the way, credit spreads will tend to be lower than they otherwise would be for a given level of creditworthiness.
3. The Fed clearly believes that the situation in Commercial Real Estate (CRE) and its effect on the banking sector is manageable. If they didn’t think so, then they would be hastening to lower rates to ease the refinancing problems that are hitting that sector. I have been reading alarmist analyses saying that the $1 trillion in CRE mortgage maturities due this year will lead to ‘hundreds’ of bank failures. This falls into the Big Number is Bad and Scary school of analysis. One trillion is a lot of mortgages and that will cripple banking! Except…
Let’s suppose that 20% of those mortgages go into default – a number more massive than we’ve ever seen before – and that recovery is 80%. For reference, in the 2008-09 crisis CRE values fell by about 36% according to the Greenstreet Commercial Property Price Index (chart below), and that was against a backdrop of 1%ish inflation. The nominal price decline should be less in an environment where underlying inflation is 4% per year, naturally. Since the CRE peak, real values have fallen 31% but nominal values only about 21% on the basis of that index. But the drop from the peak isn’t the relevant part. Even the shorter loans now coming due were struck 3-5 years ago, and the drop from that level is only about 9%. Plus, the initial loan-to-value levels were not 100%. So (and all of this is just to cuff a rough estimate) a 20% loss when selling out the collateral on a defaulted mortgage seems conservative.
Those numbers mean the $1T in mortgage maturities could produce a loss of $40bln (1,000 * 0.2 * 0.2). That’s still a big number, but remember that it is spread over a lot of banks. Suppose that it is spread over only 2,000 banks, and that the losses have nothing to do with bank size. Then you are looking at losses per bank of $20mm. That’s bad for a small bank, but the losses at a small bank will of course be smaller because they have smaller books. Will that sink ‘hundreds of banks’? Only if they are small, fairly insignificant banks.
Will some banks fail because they lent too much against commercial real estate which has fallen in value, at too-high loan-to-value ratios, and end up owning property that they can’t sell? Almost certainly. But after negotiations and forbearances and the eventual foreclosures – in an environment where the price level is rising 4% per year – I just don’t think this is something we should worry about. To be fair, the fact that the Fed is not worried about it is something that makes me worry about it.
4. I have been befuddled recently because airfare prices in the CPI have been higher than would be anticipated given the movement in jet fuel prices. Belatedly, I think I know what is going on. The issues with Boeing planes has meant that (and I didn’t know this) Boeing has greatly reduced its deliveries to airline companies as they sort out the problems with their Max jets. I became aware of this only recently when a Bloomberg story highlighted how Southwest Airlines is cutting capacity and freezing hiring because they aren’t getting the planes they need. Steady demand and constraints on supply means higher airfares, as I also discovered this week when I was booking a flight to Chicago. Yikes! With jet fuel prices also rising again, this is something to factor into CPI forecasts going forward. It’s surely ‘transitory,’ but it takes a long time to build a plane and in the near-term this is more likely to be solved on the demand side if we have a recession, than on the supply side with a sudden influx of planes.
The Powell of Positive Thinking
Yes: Federal Reserve Chairman Powell was very hawkish at his Congressional testimony on Tuesday and Wednesday. He clearly signaled (again) that once Fed overnight policy rates reach a peak, they would not be declining for a while. He additionally signaled that the peak probably will be higher than previously signaled (I’ve been saying and thinking 5% for a while, but it’s going to be higher), and even signaled the increasing likelihood of a return to 50bp hikes after the recent deceleration to 25bps.
This latter point, in my view, is the least likely since all of the reasons for the step down to 25bps remain valid: whether the peak is 5% or 6%, it is relatively nearby and the confidence that we should have that rates have not risen enough should therefore be decreasing rapidly. Moreover, since monetary policy works with a lag and there has been very little lag since the aggressive tightening campaign began, it would be reasonable to slow down or stop to assess the effect that prior hikes have had.
But here is the bigger point, and one that Powell did not broach. There is really not much evidence at all that the Fed’s hikes to date have affected inflation. It is completely an article of faith that they surely will, but this is not the same as saying that they have. Consider for a moment: in what way could we plausibly argue that rate hikes so far have been responsible for the decline in inflation? The decline in inflation has been entirely from the goods sector, and a good portion of that has been from used cars returning to a normal level (meaning, in line with the growth in money) after having overshot. How exactly has monetary policy driven down the prices of goods?
This is not to say that higher interest rates have not affected economic activity, and this (to me) is the real surprise: given the amount of leverage extant in the corporate world, it amazes me that we haven’t seen a more-serious retrenchment. Some of this is pent-up demand that still needs to be satisfied, for example in housing where significant rate hikes would normally dampen housing demand substantially and seems to have. However, there is a severe shortage of housing in the country and so construction continues (and home prices, while they have fallen slightly, show no signs of the collapse that so many have forecast). Higher rates are also rippling through the commercial MBS market, as many commercial landlords have inexplicably financed their projects with floating rate debt and where the cost of leverage can make or break the project.
Higher interest rates, on the other hand, tend to support residential rents, at least until unemployment eventually rises appreciably. I think perhaps that not many economists are landlords, but higher costs tend to not result in a desire to charge lower rents. On the commercial side, leases are for longer and turnover is more costly, but the average residential landlord these days is not facing a shortage of demand.
So where have rate hikes caused inflation to decline? Judging from the fact that Median CPI just set a new high, I think the answer is pretty plain: they haven’t. And yet, the Fed believes that if they keep hiking, inflation will fall into place. Where else can we more plainly see at work the maxim that “if a piece doesn’t fit, you’re not using a big enough hammer?” Or maybe, this is just a reflection of the notion that if you want something bad enough, the wanting itself will cause the thing to happen. [N.B. this is really more in line with the prescription from Napoleon Hill’s classic book “Think and Grow Rich”, but the title of Peale’s equally-classic “The Power of Positive Thinking” suggested a catchier title for this article. Consider it poetic license.]
Moreover, what we have seen is that higher interest rates have had the predicted effect on money velocity. Although I have elsewhere noted that part of the rebound in money velocity so far is due to the ‘spring force’ effect, there is substantial evidence that one of the main drivers of money velocity is the interest rate earned on non-cash balances. Enough so, in fact, that I wrote about the connection in June 2022 in a piece entitled “The Coming Rise in Money Velocity,” before the recent surge in velocity began. [I’d also call your attention to a recently-published article by Samuel Reynard of the Swiss National Bank, “Central bank balance sheet, money, and inflation,” where he incorporates money velocity into his adjusted money supply growth figure. Reynard is one of the last monetarists extant in central banking circles.]
Now, nothing that I have just written is going to deter Powell & Co from continuing to hike rates until demand is finally crushed and, according to their faith but in the absence of evidence to date, inflation will decelerate back to where they want it. But with long-term inflation breakevens priced at levels mirroring that faith, it is worth questioning whether there is some value in being apostate.
Food Fight at the Fed!
Now, now, children! Stop fighting! This is unbecoming!
It is apparent now that the disagreements in the FOMC – while nothing new – are becoming more significant and the hurly-burly is spilling into the public eye. It is somewhat amazing to me that the Fed is allowing this argument to be conducted in public (traditionally, all remarks by Fed officials are first vetted by the Chairman’s office). Today Dallas Fed President Richard Fisher actually questioned the Fed’s credibility! This article is worth reading, and not just for the part where Fisher says that Yellen is “dead wrong on policy.” It’s also fascinating that Fisher attributed the decision to delay the taper to “a perceived ‘tenderness’” in the housing recovery.
Below is a chart (source: Enduring Investments) of the ratio of median existing home sale prices to median household income. If this is “tenderness” in a recovery, it only shows a lack of knowledge of history: this is the second highest ratio of home prices to income we have since this particular data begins…and the first highest ratio sunk the global economy for a half-decade and counting.
On the other side of the fence were the New York Fed’s Bill Dudley and the Atlanta Fed’s Dennis Lockhart, who lamented that (Dudley) there has been no pickup in the economy’s “forward momentum” and asked (Lockhart) “Is America losing its economic mojo?” These questions, and the result of these questions during the recent FOMC meeting, illustrate two points. First, that the bar for removing never-before-seen levels of monetary accommodation has been raised so high that doves believe it is appropriate to keep the foot on the accelerator until growth is drastically above-average. As I illustrated back at the beginning of August, it is unreasonable to expect more than about 200,000 new jobs per month to be created by the economy. Repairing all of the damage is simply going to take time. We would all love to see 5% growth, but is the Fed’s job really to make sure that happens, or to try and manage the downside (or, as I personally believe, to merely manage the price level)?
The second point that the Fisher/Dudley/Lockhart comments illustrate is that the doves at the Fed are clearly in control. The hawks were completely unable even to get a marginal tapering, although the Fed had clearly indicated previously that such a taper was likely to happen.
It is a Dudley/Bernanke/Yellen Fed (and they have allies too!), and anyone who thinks that the Fed is abruptly going to find religion once CPI peeks above 2% is fighting against all historical indications. One need only consider the fact that the post-FOMC meeting statement pointed out a “tightening of financial conditions observed in recent months,” a clear reference to the rapid rise in interest rates that accompanied the initial talk about tapering. But if the Fed begged off on the taper partly because of the tightening of financial conditions, that is the rise in interest rates that was caused by an expectation that the taper would stop, then the argument circular, isn’t it? It’s impossible for them to stop, since any indication that they were going to stop is obviously going to cause interest rates to rise, which would be a tightening of financial conditions, which would keep them from stopping… Does anyone seriously think that a core inflation print of 2.1% would change that?
To the extent that cutting from 20 cups of coffee per day to 19 cups of coffee per day could be called a “bold step,” wouldn’t the best time to take such a “bold step” with monetary policy be when the equity markets are at their highs and real estate markets back above their long-term value anchors?
And yet, the initial enthusiasm for the stock market for the continuation of QE seems to have faded rapidly. The entire post-FOMC rally that caused such joy around the offices of CNBC last Wednesday has been erased. Interestingly, the initial spike in commodities prices has also been erased, which is more curious since commodities prices don’t depend on growth as much as they do on inflation. And 10-year inflation expectations are back around 2.25%, basically the highest level they have seen since the Q2 swoon (see chart, source Bloomberg). So, as usual, I am flummoxed by the behavior of commodities.
I know that there is a great deal of confidence in some quarters that the Federal Reserve can keep its foot on the gas until such time as inflation actually rises to a level that concerns them. I cannot imagine the reason for such confidence when the drivers of the car are such committed doves. There are multiple problems undermining my confidence in such a possibility. There is the “Wesbury hypothesis” that the Fed will adjust its definition of what worries them about inflation – a hypothesis which, after this month’s FOMC meeting, should be even more compelling. There is the fact that there is no evidence I am aware of that the Fed was able to easily restrain inflation after it came unglued in any prior episode (and no one knows where and when and how it will come unglued). And finally, it isn’t clear to me how the Fed would go about restraining inflation anyway, given the overabundance of excess reserves and the fact that those reserves insulate any inflation process against the tender ministrations of the central bank.
One thing seems to be sure. The food fight at the Fed is not likely to end soon, and together with the dysfunction on Capitol Hill is raises the very real question of whether anything economically helpful is going to be accomplished in Washington DC this year.
Transparently Dovish
Markets are finding it a little hard to believe that the Fed really said what it said. Stocks opened the day with a rally, along with commodities and bonds and especially TIPS. All of these markets leapt forward out of the gate, which is a completely understandable response. I was pretty clear in yesterday’s comment, but there were a couple of additional points that I either ignored or gave short shrift.
The first of these is that while I mentioned that Bernanke said “we’re not absolutists” about inflation, that really doesn’t capture the idea as clearly as he said it. Here is the full quote (and thanks BN for reminding me):
We are not absolutists. If there is a need to let inflation return a little bit more slowly to target to get a better result on unemployment then that is something that we would be willing to do.
It is hard to read that as anything except probably the single most-dovish thing that a Fed Chairman has said in eons. He explicitly states, essentially, that not only is employment as important as inflation in the FOMC’s consideration of its mandate, but that at this time inflation is actually subordinate to employment. This is essentially a vague form of the Evans Rule, which Chicago Fed President Evans proposed as a way to semi-formally declare that inflation doesn’t matter until (a) it’s out of control or (b) unemployment gets down to some certain level. Formally, it would read something like “the Fed will keep rates at zero and tolerate 3% (or 4%) annual inflation until unemployment is down to 7% (or 6%).” I wrote about this back in early November, never dreaming that it had a serious chance to become policy. It’s worse than policy now – it has a mushy informality that is guaranteed to make any ultimate decision to raise rates in restraint of inflation even more difficult. Back in November, I expressed my opinion of such a rule, and I must say I don’t disagree with this comment:
If they do take such a step, though, it is an unmitigated disaster for monetary policy and a sign to grab every real investment in sight. Because allowing 3% or 4% inflation has nothing to do with the Unemployment Rate, and moreover there is no sign that the Fed has anything like the kind of power they would need to lock the inflation rate at any particular level. Such a statement would mark a surrender against inflation in order to make a Quixotic charge on unemployment. If the world’s largest central bank goes that route, then bill-printers of the world unite! You have nothing to lose but your change.
It is inexcusable that I didn’t carry the “absolutist” quote to its full length and implication. But I also missed a small subtlety that is less egregious. The Fed, in stating formally that 2% inflation “is most consistent over the longer run with the Federal Reserve’s statutory mandate,” already nudged the goalposts a bit. For some time it has been tacitly understood and occasionally communicated explicitly in speeches that the Fed operated as if it had a target of 2%-2.25% on core CPI inflation. The Fed has long preferred the core PCE Deflator as a measure of inflation, and the PCE deflator has generally run around 25bps lower than core CPI over time, so the 2-2.25% CPI target was really a 1.75%-2.00% target on core PCE.[1] By saying that the Fed’s informal target was 2%, the Committee (a) nudged the target up slightly from 1.75%-2.00% to just 2.00%, and (b) made clear that inflation can go at least another 0.3% higher before it even gets to the target, and probably wouldn’t alarm them until it was at least 0.8% higher than the current level. That would be a core CPI inflation rate around 3.0%, well above the current level. No wonder they aren’t alarmed at the strong, steady advance in core CPI!
Investors seem to barely believe their ears. While commodities ended the day +0.4%, stocks slipped into the red. Still, the equity chart to me bears an uncanny resemblance to the chart in the months following Bernanke’s Jackson Hole speech in which he essentially announced QE2 (see Chart, source Bloomberg).
Narrow ranges, steady advancement, and all on top of markets that were not cheap to begin with. Today’s selloff of a mere -0.6% doesn’t alarm me and I think equities will continue to climb, although commodities offer much more inflation “beta” at this stage of the cycle and with negative real rates.
In my view, this action is no less clear a sign that the Fed is going to continue to pump liquidity into the markets than Bernanke’s speech was in the summer of 2010. It is much more remarkable, in that back then core CPI was preparing to print a low of 0.6% and now it is 2.2% and rising, but it is not much less clear. After all, that has become the Fed’s game: transparency, transparency, transparency.
For a very long time (as in, more than a decade) I have been railing about how Fed glasnost is a bad idea with no real upside. It has generally been pretty lonely to have that view, since “transparency” seems like a good thing and in many areas of government we could use lots more. But I was pleased today to get news of a speech from former Fed Governor Warsh in which he said the transparency has gone too far:
Central bank transparency is good, but transparency that delineates future policy breeds market complacency. It threatens to undermine the wisdom of the crowds and the essential interchange with financial markets.
Now, I’ve said similar things in the past about transparency and market complacency – overconfidence breeds over-leverage; if you want to cause deleveraging then the Fed should start doing unpredictable, random things like moving the Fed funds rate 17bps one day and then moving it back the next day, or only making moves in prime numbers, or scheduling an FOMC ‘tea’ instead of a board meeting. Act crazy and investors will keep a bigger margin of safety, which means they will use less leverage. But Warsh raises another very interesting and important point that I haven’t noticed before: if the Fed is too busy telling the market what to do, it can’t be listening to the market to learn what to do. When you think about it, aside from arrogance this conveys a mistrust of markets that is a hallmark of liberal institutions. Failed liberal institutions.
In economic data today, Durable Goods and Chicago Fed came in strong, while New Home Sales was soft but at continued low levels which makes them irrelevant in any event. Initial Claims was roughly on-target (but we’re still in the choppy year-end waters during which Initial Claims can be ignored). But all of this is back-seat stuff if the Fed is pressing pedal to the metal.
Friday introduces another weekend filled with searing promise for solutions in Europe; and the weekend precedes a Monday stuffed with bitter disappointment. It seems to happen every week, and I don’t see any reason it should differ this week.
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One quick note: in August 2010 I wrote an article called “The ‘Real Feel’ Inflation Rate,” in which I discussed a paper I’d written discussing how economists might go about assessing quantitatively how inflation feels as distinct from how it is precisely measured. I’m pleased to report that the paper has finally been published in this month’s Business Economics, the journal of the NABE. It’s only available to subscribers, unfortunately, but membership in the NABE is only $150 per year online. (I am not a member, so consider this a public service message). I should mention that I am looking for a corporate partner who would be interested in developing the methodology and perhaps commercializing such an index – contact me if you are interested or know of someone who is.
[1] There are several differences between PCE and CPI. One important one at the moment is that the PCE deflator has a higher weight in housing, so it’s currently at 1.70% on core, but there are other differences as well covering the functional form, the items that are included or excluded for each one, and the weights for those. There may be a very slight reason to prefer PCE as a technically ‘better’ index, but there is a large reason to prefer CPI and that is that there is an explicit market price for inflation expectations in CPI form: inflation swaps. There is no such market price for PCE. So I don’t think the Fed has made the right decision anyway.
