The Fed's Quest for the Holy Grail

June 25, 2021

The Federal Open Market Committee (“FOMC”) met on June 15-16 and the results of that meeting dominated financial headlines last week and whipsawed the market. We didn’t comment much on the move as we wanted to see how the “reflation” selloff played out over the following week, as we thought that particular episode might be “transitory”. After watching the market decline in the initial days, it’s staged a remarkable rally since and fully recovered its prior week losses as we write this.

As we’ve noted before, we’re in the most EPIC of liquidity parties. These are the times of froth and anything less than awesome will surely be a buzzkill, and most definitely unwelcome. More importantly, anything that brings us down from our buzz could send us reeling, which is why the Fed’s guidance was so closely watched.

To be sure, the rising markets can be attributable to both profligate fiscal spending and accommodating monetary policy, but we’ll focus on the the latter this week and address the former as details of the latest infrastructure bill are still trickling out.

Meet the FOMC

The FOMC meets 8 times a year, and of late, with the financial markets debating inflation data, and much uncertainty over whether inflation is transitory or secular, each meeting becomes that much more dramatic. How are they seeing inflation? Will they taper QE, will they increase interest rates? When? The answers to all of those questions will factor into when the bartender will begin announcing “last call,” and for investors it’s not a message you want to miss.

When Mandates Compete

Now remember the Fed has two mandates: price stability and maximum employment.  Both go hand-in-hand, but the policies used to promote one may not align with the other. It’s akin to a never ending quest for the Holy Grail, and like the Monty Python movie, can become comical. We’ve written about the Fed’s pivot last year, whereby the central bank started welcoming/spurring higher inflation to compensate for the years of low inflation. As the Wall Street Journal put it then:

“That increases the economic risk that the Fed might end up looking through inflation until it’s too late. Having effectively admitted it no longer fully understands the relationship between economic growth, employment and inflation, the Fed still promises to decide in real time when its healthy above-target inflation has become dangerous. If the central bank gets this wrong, it could be forced to raise rates much higher, much faster than it would want.”

As we noted

“Just think about this for a second here. What in essence happened to the Fed’s long-term policy goals this week was the effective abandonment of price stability.  Setting an objective 2% inflation rate gave the Fed and market participants a hard target to take aim for.  It heightens stability and predictability because as we approached the mark, the market and consumers can begin to react as they know what to expect from the monetary authorities.  Now the guardrails are off.  We’ve stopped bumper bowling.”     

The Fed’s earlier shift from being proactive to reactive means that it will not only tolerate, but favor higher inflation, aiming to overshoot its 2% inflation target to compensate for years of low inflation.  The Fed’s new strategy has since been termed “average inflation targeting” (“AIT”).

Many on Wall Street questioned how sticky this pivot would be given inflation could quickly leap upwards and surprise to the upside, but during the depths of 2020, a fast recovery seemed like only a dream amidst the COVID nightmare. Sure enough the Fed doubled-down in June 2020 and said about its loose monetary policy . . .

“We’re not thinking about raising rates, we’re not even thinking about thinking about raising rates.” - Fed Chairman Jerome Powell

As another COVID wave hit, there was no doubt the Fed was going to continue its dovish stance on monetary policy. 

A year later? 

That plot has twisted, and as the US vaccines worked their magic, our economic recovery accelerated.  So quickly in fact that our supply chain lagged in meeting the higher demand.  Consequently inflation indices began flashing higher figures.

It also figures to continue doing so as we head into H2 2021, base effect and all.   

Thinking to Talking Now

As inflation heated up, the Fed’s resilience in the face of higher prices has been questioned, and last week they began answering that question.  The Fed Chairman said

“You can think of this meeting that we had as the ‘talking about talking about’ meeting.” 

Clever.

Here’s the thing. The beauty of adopting AIT and the “inflation is transitory” narrative is that it allows the Fed to continuously stimulate the economy in pursuit of maximum employment without facing the normal political repercussions of doing so. Price instability (i.e., above trend inflation/deflation) is what typically forces the Fed to dial-back its loose monetary policies, and even though inflation is raring its head, the Fed can overlook it. AIT and the “inflation is transitory” narrative gives them enough cover/leeway to continue their dovish stance (QE / low interest rates) despite arguably violating one mandate (price stability) in the pursuit of the other (maximum employment). Yet despite the free pass, why the tonal shift last week? 

We think it’s a credibility issue.  After a tumultuous Trump administration, and criticisms stemming from the Great Financial Crisis, the Fed and its members don’t want the blame for another runaway bubble and subsequent crash.  Moreover, why should it?  The economic stimulation is coming from two different sources, monetary policy and fiscal spending.  The Fed controls the former, but only enables/facilitates the latter. If the politicians run amok, then doesn’t the larger responsibility fall on them?  Do they really need the shoulder the responsibilities of both policies if they’re already receiving intense criticism on their current plans? Besides, they’re well aware that the Fed is the lender of last resort if things get “squirrelly",’ which means that the sensible thing to do, the more cautious thing to do, is to begin talking the market down (i.e., put some guardrails back in place).

So hence, the “talking about talking about” talk. As some commentators have correctly pointed out, practically, the Fed hasn’t done anything. As expected, the FOMC left short-term interest rates near zero, and continues to implement QE, purchasing Treasuries and mortgage backed securities to the tune of $120B a month (and more of late).  Again, all with the outlook that near-term inflation is transitory, and there’s little reason to lift the foot off the gas.  Even so, the talk of “talking about talking about” is important, because on a longer time horizon, it does indicate that the Fed won’t allow this train to careen uncontrollably off the inflation track.  Despite AIT, “talking about talking about” raising interest rates means tamping down inflation in the longer-end of the curve as they discuss taking the punch bowl away.  We’re not at last call yet, but the bartenders are telling patrons they’re sure looking at the clock.  

So this pivot is important, and we think dialing back makes sense as our economy roars back.  It does set-up for more volatility in the coming months because again remember the Fed’s two mandates, price stability and maximum employment.  By allowing prices to climb during a “transitory” period, it better also see employment do the same. So watch the interplay between the inflation and jobs number in the coming months, stronger than expected figures could nudge the Fed to get more aggressive (in 2022). We know that’s still a year away, but the distance between dovish and hawkish may be considerably shorter than we think.

As we can see, the FOMC’s “dot plot” (a survey of where the members think interest rates should be in the near future) has begun to moving higher and sooner. What the dot plots don’t indicate though is the conviction level of each Fed member. So if inflation isn’t quite so transitory, but employment recovers quickly, certain Fed members might just turn into swallows and cover that dovish to hawkish distance quickly. We all know the incredible airspeed velocity of those unladen birds . . . African and European.

Speaking of which, watch the emerging markets (“EM”).  Inflation will certainly hit those regions harder as their debts are denominated in USD and their populations are much more sensitive to food and energy price increases.  Brazil, Russia, Chile, etc. have begun lifting rates as they aim to strengthen their currencies and control inflation to the best they can. If the US begins to tighten (or indicates it will), expect the EMs to race further ahead. 

Lastly, the next important meeting to watch is the Fed’s upcoming annual policy symposium in Jackson Hole, Wyoming from August 26-28. The yearly retreat hosts the world’s top central bankers and economists, and is an occasion where members tend to float policy shifts. As Bloomberg notes:

“Jackson Hole is traditionally scrutinized for hints on upcoming Fed policy changes. It will be again this year, with attention on whether Chair Jerome Powell will make a speech and use the occasion to indicate that the U.S. economy has made “substantial further progress” on employment and inflation as a prelude to scaling back massive bond purchases -- assuming he’s not already delivered that signal.”

So when the doves, hawks, or swallows start singing, we’ll be all ears.