Moderate Monetary Policy: Vice Or Virtue?

By: Michael Ashton | Thu, Jul 11, 2013
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Barry Goldwater once said "Extremism in the defense of liberty is no vice. And moderation in the pursuit of justice is no virtue." It is one of the great quotes of the 20th century, and so I feel moderately guilty to convert it to my own selfish uses by saying that "Extremism in the defense of bad monetary policy is no virtue. And neither is moderation in the attack on inflation."

And that, for the most part, is the story of the day.

Much of the day's trading session was as languorous as the Bermuda-shorted walkers on Lexington Avenue in the wilting, moist heat of the New York summer. But, late in the day, the release of the minutes from the last FOMC meeting and the subsequent question-and-answer session from Chairman Bernanke roused traders and rattled markets.

The minutes themselves were filled with comments on inflation that are likely to be held up as articles of ridicule in only a few months.

The extremism of St. Louis Fed President Bullard, in defense of bad policy, summed it up: "Mr. Bullard dissented because he believed that, in light of recent low readings on inflation, the Committee should signal more strongly its willingness to defend its goal of 2 percent inflation. He pointed out that inflation had trended down since the beginning of 2012 and was now well below target." He was not alone, as "...most participants...anticipated that [inflation] would remain below the Committee's 2 percent objective for some time."

If by "some time" they mean "several months," then I suppose this will end up being right. But there is very little doubt that core inflation will be over 2% very quickly, unless some interesting data quirk provides an encore to the Medicare-induced decline in core CPI over the last six months. This is where good analysis is supposed to play a role. The chart below (Source: Bloomberg) shows core CPI, along with another measure of the central tendency of inflation: the Cleveland Fed's Median CPI.

Cleveland Fed's Median CPI

Now, in this column I have written quite a bit previously about what exactly is happening to core CPI, and why we shouldn't pay too much attention to its recent decline (in summary: it is all in core commodities and especially pharmaceutical prices, while the biggest chunk of CPI, housing, is in the process of turning higher). But the point of this chart is that the deviation in core CPI compared to median CPI should be a clue to the thoughtful analyst to look more closely at what is going on, since the median is barely moving - and remains above 2% - while the average is declining. What this tells you, statistically, is that there are a few big outliers to the downside that are skewing the core reading lower. It is upon further investigation that the observation about housing-versus-pharmaceuticals (which cause core PCE to be even lower, since core PCE exaggerates the effect of medical care while understating the importance of housing) ought to be crystal clear. You don't have to be an inflation expert to figure that out. You just need to look at the data carefully. It takes a bit more expertise, but not a ton, to observe that the second half of the year should see core inflation rise because of easy comparisons to the year-ago period, if for no other reason.

And the Fed came to the right conclusion...

"Several transitory factors, including a one-time reduction in Medicare costs, contributed to the recent very low inflation readings. In addition, energy prices declined, and nonfuel commodity prices were soft..."

...and then butchered the forecast for higher core inflation by incorrectly attributing it:

"Most participants expected inflation to begin to move up over the coming year as economic activity strengthened..."

It's a simple forecast (although the rise will be more than they expect it to be), and they at least got the sign of the movement in inflation right. Maybe they even got the causes right, privately, but just felt it was too hard to explain in the minutes.

But, I doubt it.

The FOMC participants are not expecting, as it also says, inflation to move above 2% (on core PCE, which would be somewhat higher on core CPI). It's a very marginal forecast they are making here. More extremism, though, was provided by the IMF's Chief Economist Olivier Blanchard, who said in an interview that he is "not at all worried about inflation" in the U.S., because in his view (although stated as fact) inflation can rise because of an overheated economy or people's expectations of cost increases. People, said Blanchard, who fear a jump in prices are "plain wrong."

What is plain wrong is that they picked a guy to be chief economist who doesn't understand the first thing about inflation. Virtually no one who has studied the matter believes that inflation expectations cause inflation. This is because there is nothing remotely suggestive of that in the data (and, moreover, no one can figure out how having customers who are afraid of cost increases can cause a vendor in a competitive marketplace to jack up prices with no other reason). Many people believe that an "overheated economy" can cause inflation to rise, so that's at least a more common error, but consider that that core inflation fell in the U.S. from 1995-1999, and then rose from 2000 to 2002. Consider that it fell from 2006 to 2008 with unemployment below 5% and then rose sharply in 2011 with unemployment around 9%. Given that, is it unreasonable to ask that a chief economist at least be less strident in his statement about how plain wrong everyone else is?[1]

There was some volatility on the release of the FOMC minutes, with inflation markets getting pressured modestly on the theory that the minutes were not quite as dovish as was hoped, and there was at least some fair discussion about the importance of holding down inflation. Eventually, that is. But inflation breakevens as well as commodities prices (and stocks, and bonds, etc) rallied when Chairman Bernanke took some questions after his speech in Boston. In his responses, he backed off the recent tapering signals further - really, they've been backpedaling so fast on this that they're behind where they started - by saying that inflation and the state of the jobs market indicates that more Fed stimulus is needed. The fact that this comment, myopically focused on the very short run followed a speech with the grand title of "The First 100 Years of the Federal Reserve: The Policy Record, Lessons Learned, and Prospects for the Future" was an irony apparently lost on the Chairman.

But, hey, let's face it. He's going to be gone when the important work of policy normalization gets started. As the President said recently, he's stayed far longer than he wanted to. Is it unreasonable to expect him to just be 'phoning it in' at this point? Yet his moderation is no virtue, especially if you own fixed-rate bonds or other assets that will perform poorly when inflation rises.


[1] I, on the other hand, am free to do so since I am not the Chief Economist of the IMF nor the Chairman of the Federal Reserve, and moreover because no one much cares what I think. Ah, the freedom of irrelevance!

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Michael Ashton

Author: Michael Ashton

Michael Ashton, CFA

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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