Transparently Dovish

By: Michael Ashton | Fri, Jan 27, 2012
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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).

SPX

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.

 


 

Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA
E-Piphany

Michael Ashton

Michael Ashton is Managing Principal at Enduring Investments LLC, a specialty consulting and investment management boutique that offers focused inflation-market expertise. He may be contacted through that site. He is on Twitter at @inflation_guy

Prior to founding Enduring Investments, Mr. Ashton worked as a trader, strategist, and salesman during a 20-year Wall Street career that included tours of duty at Deutsche Bank, Bankers Trust, Barclays Capital, and J.P. Morgan.

Since 2003 he has played an integral role in developing the U.S. inflation derivatives markets and is widely viewed as a premier subject matter expert on inflation products and inflation trading. While at Barclays, he traded the first interbank U.S. CPI swaps. He was primarily responsible for the creation of the CPI Futures contract that the Chicago Mercantile Exchange listed in February 2004 and was the lead market maker for that contract. Mr. Ashton has written extensively about the use of inflation-indexed products for hedging real exposures, including papers and book chapters on "Inflation and Commodities," "The Real-Feel Inflation Rate," "Hedging Post-Retirement Medical Liabilities," and "Liability-Driven Investment For Individuals." He frequently speaks in front of professional and retail audiences, both large and small. He runs the Inflation-Indexed Investing Association.

For many years, Mr. Ashton has written frequent market commentary, sometimes for client distribution and more recently for wider public dissemination. Mr. Ashton received a Bachelor of Arts degree in Economics from Trinity University in 1990 and was awarded his CFA charter in 2001.

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