It is very easy to reflect on economic events and criticise policy makers for their past decisions. Commentators do this all the time. It is almost as if they believe they alone possess perfect foresight. They do not.
It must be appreciated that perceptions about adjustments to monetary policy, and what they are intended to achieve, can only be described as speculative. Shifts in policy are responses to unforeseen outcomes, and because policy makers are not soothsayers their policies need to evolve as events and data change.
Right now, the main preoccupation for market participants is forecasting inflation which is currently running hot in the US. However, only one thing is certain about its future trajectory -it cannot be predicted with certainty. This shortcoming, and the feeling it evokes, is one of the main sources of volatility in the market right now. Not only are investors trying to predict inflation, but they are also trying to construct what type of policy will be needed to control it. Both thankless tasks and despite many best efforts most are being wrong footed.
Expectations for growth, inflation and interest rates are continually changing. This can be seen in Chart 1. Investors now think interest rates in the US will hit 1.3% over the next 12 months whereas 2 months ago the implied policy rate for the same period was 0.7%. In other words, interest rate expectations have virtually doubled in just 2 months.
Chart 1: Fed Policy Expectations
Source: Bloomberg, 2021
There is a very logical reason for this shift. Inflation is no longer being talked about as transitory. The possible risks and outcomes from policy change to combat sticky or persistent inflation are now extremely wide. The pandemic and the fact that many policy makers and market participants challenging the Fed, have never worked through a high inflationary environment are two key influences heightening the challenges.
What is clear to us is the risk of policy error has grown and so it makes sense to use a framework for assessing how Federal Reserve (Fed) policy actions will be judged later. We also expand our thoughts to consider the implications of the Fed being right or wrong on policy. For us nothing is clear cut or without risk (which underpins why we are passionate about diversification!).
The Aggressive Approach: If the Fed hike rates too quickly and by too much, growth and inflation will collapse; and they will have acted too aggressively. Under this scenario the economy lapses into recession and the Fed will have wrongly positioned themselves well ‘ahead of the interest rate curve’.
The Cautious Approach: If the Fed seriously underestimate inflation, policy will have been too loose. Growth and inflation will move higher, and rates will not be increased enough nor at a fast enough pace. In this scenario the Fed will have placed themselves, again wrongly, but this time ‘behind the interest rate curve’: Ironically, being wrongly cautious will ignite aggressive policy, as happened late 1970 early 1980 when Chairman Volker oversaw the Fed and had to stamp down on inflation.
The Right Approach: What this is exactly is unknown. It requires the Fed to walk the proverbial tightrope. Some commentators refer to the outcome that the right approach produces as ‘the Goldilocks Scenario’.
We know with reasonable certainty that the Fed are allowing inflation to run higher expecting it to cool later this year. Longer run they may also accommodate higher inflation. Higher than was experienced over the last cycle. Something around 2 to 2.5%. This is because they do not want to take risks with growth at a time of pandemic related uncertainty.
The Fed have stopped using the word “transitory” to describe inflation, creating a notion that higher prices will persist. The approach of allowing ‘more inflation’ does allow more headroom for rates to be marginally behind the curve. It pushes necessary adjustments into the future. However, any need for sizeable backtracking, to embrace a more aggressive approach, would lead to heightened volatility.
Much like Goldilocks tasting the bears porridge, the Fed are sampling the economy to see if it is too hot or too cold while aiming for something that is ‘just right’. A policy tilt too much in either direction will have great implications for all of us. In this regard economists, market commentators and investors should not place all their chips on one specific inflation outcome.
Concluding Thoughts
Predicting inflation with high conviction is not recommended.
The market is watching and judging the Fed at every twist and turn, and the risks of policy error have grown.
The primary goal for the Fed is to find a policy response that is “just right”, helping dampen the impacts of inflation, while still allowing growth to proceed. They are at pains to avoid boxing themselves into a corner. They need headroom for any changes that may be necessary for as long as the pandemic prevails.
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