"Trying to understand the way nature works involves a most terrible test of human reasoning ability. It involves subtle trickery, beautiful tightropes of logic on which one has to walk in order not to make a mistake in predicting what will happen. The quantum mechanical and the relativity ideas are examples of this."
Richard P. Feynman
New York | Over the past week, many thousands of words have been written regarding the latest pronouncement from the Federal Open Market Committee about inflation and monetary policy. Led by Federal Reserve Board Chairman Jerome Powell, the FOMC has discarded the statutory mandate from Congress regarding “price stability” and is now pursuing a long-term average for inflation based on the central bank's shifting definition of aggregate prices.
Many analysts offer as many reasons for this change, but the basic message to the markets is that interest rates now have a permanent downward bias. Whereas in the past the committee followed a measured and preemptive approach to managing inflation, now the FOMC intends to let inflation run at or above 2% for a while. How long? That is the difficult part in the new world of monetary relativity.
George Selgin of CATO Institute nicely describes the FOMC’s transition to nominal GDP targeting. “Since Jay Powell announced the Fed's new average inflation targeting (AIT) strategy last week, both Scott Sumner and David Beckworth have welcomed it as a step, albeit only a tenuous one, toward their own (and my) preferred policy of NGDP level targeting,” Selgin writes. “Scott calls ‘average inflation targeting…a tiny step forward,’ though one that will allow the Fed more discretion than a move to price-level targeting would. David likewise observes that, although it isn't quite an NGDP level target, AIT "is a step in that direction." Ditto.
The idea of the FOMC deciding when AIT has made up for periods of price deflation seems to stretch to the breaking point the elastic “necessary and proper” clause of the Constitution, which allows agencies of the federal government to take those actions required to implement the will of Congress. But the law still says “price stability.” Is it necessary for the FOMC to have AIT or merely convenient?
“The telling part of the problem with the new strategy came during the press conference,” notes Robert Eisenbeis of Cumberland Advisors, “when Chairman Powell struggled to answer several pointed questions about how long inflation would remain above 2%, how is “moderately above 2%” for inflation defined; how maximum employment is defined, why inflation above 2% didn’t show up in the SEP, and how and under what circumstances the asset purchases program might be stopped. All in all, few if any actual specifics were provided, which leaves us to wonder whether, at this time, the Committee simply hopes it can get inflation up, hopes it can achieve a 2% average rate, and hopes it can get back to full employment sometime in the future.”
Of note, the FOMC announced that it will continue its monthly asset purchases under this latest version of quantitative easing or QE. Chairman Powell, during the press conference, indicated that $80 billion would be in Treasuries across the curve and $40 billion in agency MBS, so as to support “the flow of funds to households and businesses.”
As we’ve noted in the past, the FOMC policy of Financial Repression encourages debtors but punishes savers, as illustrated by the fact that the Fed remits the interest earned on $1 trillion in MBS to the Treasury, depriving private investors of this income. While the FOMC’s policies are certainly encouraging mortgage backed securities issuance, other sectors remain subdued due to the damage done to the markets by the volatility in March and April and before.
Notice that new mortgage debt issuance is now over $400 billion per month. One of these days, we’d love to see Chairman Powell and the other members of the FOMC document to Congress why they think that the net, net impact of quantitative easing and low interest rates are actually a benefit to the US economy.
Nathan Tankus writes in Notes on the Crisis that the FOMC’s repudiation of its earlier policy stance on inflation when it isn’t coming in “above target” is significant. He opines: “This is important because it is a concrete illustration that the Fed has shifted to a more ‘dovish’ policy and away from its historic tendency to generate unemployment to preempt rising inflation.”
That the American political system cannot tolerate even a brief period of induced pain to forestall inflation illustrates a larger problem, namely that the US financial system cannot tolerate much in the way of liquidity stress either. Thus the clear message from Powell is that the circumstances that caused the committee to raise the federal funds target and shrink the system open market account in 2018 will not be repeated.
The change to the Fed’s operating parameters in a financial sense is as much operational and it is monetary. The Fed has now capitulated to the debtors in the global economy and, operating through the Federal Reserve Bank of New York, will provide whatever liquidity is needed to keep the game moving in the financial markets.
Powell’s action is the functional equivalent of the FOMC removing the snakes from the gameboard of Snakes & Ladders, an ancient Indian competition between the ladders of virtue (karma) and the dissolution and ruin of the snakes (kama). Going forward, the FOMC will provide whatever support is required to target nominal market stability along with NGDP. Embracing AIT takes away any practical limit on Fed liquidity injections, contrary to the intent of Congress in the Dodd-Frank law.
The change in the FOMC’s stance also reflects a rebuke to the remaining conservatives within the decidedly left-of-center Fed system, the once powerful staffers and Reserve Bank Presidents who followed the legal mandate from Congress explicitly. Game over. Powell’s actions are a direct and final repudiation of the supporters of former Chairman Paul Volcker, who preemptively attacked inflation in the 1970s and 1980s.
The pressure from conservative Fed cardinals in 2017 and 2018 made the FOMC to attempt to raise the federal funds market and also allow the SOMA to run off in what seems today a reckless and intemperate fashion. The market meltdown at the end of 2018 and in September 2019, as a practical matter, forced Powell et al to retreat on the target rate for federal funds and forced a re-start of QE.
As former Fed Chairman Ben Bernanke warned years ago, once given the liquidity provided by QE cannot be withdrawn. The 20-30% annualized inflation of the assets of the US banking system that results from QE is now permanent. The FOMC is now compelled to continue financing ~ $6-7 trillion in US Treasury debt at no cost more or less indefinitely.
Of course, conservative protestations about inflation are always wrong until they are right. Predicting these trends is the stuff of quantum mechanics, a science that is as much qualitative and quantitative. The inflation of the 1970s, for example, was driven by demographic factors that no longer pertain to the present day economy. Indeed, if the FOMC really wants to hit its 2% inflation target, it may need to change the definition of inflation, again.
We believe investors and risk professionals need to focus on the actions of the FOMC and not the “disappointing” narrative from Chairman Powell, to concur with Selgin, Tankus and others who closely follow Fed monetary mechanics. Note in the SIFMA chart above the sharp upward move in Treasury issuance this quarter. Those market actions, we submit, suggest that the Treasury market doggie is wagging the FOMC monetary policy tail going forward.