When the Federal Reserve changed its framework for monetary policy in August, 2020, it sounded to me like an over-reaction to the pandemic era economic malaise. Looking back, I describe that moment as peak deflationary thinking. This peak is marked by an assumption that the economy is stubbornly stagnant and biased for lower aggregate prices without the Fed’s on-going vigilance and active interference. It turned out that the pandemic delivered just the right mix of sustained economic distortions and excessive liquidity to create “persistently elevated, unactionable inflation“. In December, 2022, I explained the Fed’s challenge and the attempt at course correction in “How To Trade The Fed’s Designed Over-Correction For Inflation“:

“In the immediate aftermath of the pandemic, the Fed announced an important policy shift at that year’s Jackson Hole gathering. Going forward, the Fed would target average inflation of 2% instead of 2% as a point destination. Moreover, the Fed crystalized its goal to drive unemployment as low as possible via ‘assessments of the shortfalls of employment from its maximum level.’ Years and decades of deflationary drags facilitated this shift, and the economic crisis from the pandemic seemed at the time to further entrench these deflationary forces. Interest rates seemed destined to stay lower for longer…I claim this policy framework encouraged the Fed to be overly optimistic about the transitory nature of pandemic-era inflation, and subsequently compelled the Fed to move late toward normalizing monetary policy.”

My claims that the Fed left rates too low for too long in its ambitious effort to drive unemployment as low as possible received a resounding validation in “The Inflation Surge of the 2020s: The Role of Monetary Policy,” a “conference draft” authored by economists Gauti B. Eggertsson (Brown University) and Don Kohn (Hutchins Center on Fiscal & Monetary Policy, Brookings Institution). Eggertsson presented the paper on May 23, 2023 during a 3-hour conference at the Brookings Institution titled “The Fed: Lessons learned from the past three years” (Eggertsson’s 27-minute portion starts at the 1:25 mark).

How the Fed’s Revised Policy Framework Contributed to the Inflation Surge

In this paper, Eggertsson and Kohn explore how the Federal Reserve’s monetary policy contributed to inflationary pressures in the U.S. between 2022 and 2023. In their research, they describe the inflation surge that began in March 2021 as “the largest and most persistent increase in inflation since the Great Inflation of the 1970s.” This inflation surge was unanticipated and its persistence was consistently underestimated by policymakers and economists (as well as a wide array of pundits and analysts who invariably insisted that high prices would be sufficient brakes on demand to cure inflation before economic damage occurred).

Just as I claimed the 2020 Policy Framework was the genesis of the Fed’s monetary problem with inflation, the authors did the same. They note that there were two major changes in this Framework from the 2012 version. The first change was the adoption of the Flexible Average Inflation Targeting (FAIT). This policy states, “if inflation persistently undershoots the 2 percent target it will be offset by deliberate ‘moderate’ overshoots ‘for some time’ to better assure that inflation averages 2 percent over time.” The second change was the shift to an asymmetric response to labor market deviations from “maximum employment.” This means that policy would be influenced by shortfalls from maximum employment rather than estimated or projected overshoots. Importantly, Eggertsson and Kohn propose that “an asymmetric objective function, coupled with the common assumption that policy affects activity with a lag, implies an inflationary bias.” (The paper’s appendix includes a mathematical representation of this claim).

The authors suggest that the new Framework was largely predicated on the belief that the tightness of the labor market had a limited impact on inflation. This belief was informed by the 2015 experience when unemployment declined from 5.0% to 3.7% while inflation was still undershooting the 2% target. Extrapolating from this lesson, the 2020 Framework assumed employment could expand for longer without generating inflationary pressures. Thus, there was no need to reduce accommodation preemptively as the labor market tightened.

The authors critique the 2020 Framework’s reliance on reaching maximum employment and inflation at or above 2% before increasing interest rates. This precondition led to what they call “additional inertia to the policy process,” as it limited the Federal Reserve’s ability to adapt to unexpected economic circumstances. The authors note that “forward guidance in September 2020 was well designed to avoid a repeat of a pre-emptive tightening after 2015 when there was high employment but low inflation, it was less well suited for a situation in which it was the other way around.” The forward guidance in September 2020 took its marching orders from the newly updated Policy Framework.

The inflation surge of the 2020s, beginning in the first quarter of 2021, was a sudden and underpredicted economic event. The authors observe that even after the inflation surge began, “Policy makers and the professional forecasters persistently predicted inflation to fall back toward the 2 percent target reasonably promptly.” Base effects from the brief plunge in prices after the pandemic also clouded assessments of the inflation risks. Yet, as the authors explain, “By some metrics the inflation objectives of FAIT (flexible inflation targeting) had been reached in the spring of 2021.” The Fed did not start to hike rates for another year.

Hawkish Hints Were Not Sufficient to Fight Inflation

While the Fed failed to hike rates for that year, they DID drop some hints that inflation was becoming a problem. Eggertsson and Kohn provide a timeline showing the snail’s pace of change in the Fed’s statements on monetary policy over that time, but they use it to explain the lag in policy. Statements between meetings reveal some increasing concerns despite the reluctance to act. For example, in June, 2021, I described how statements from Fed Chair Jerome Powell during the monetary policy press conference that month combined with post-meeting commentary from James Bullard, the president and CEO of the Federal Reserve Bank of St. Louis, to give the Fed a hawkish bias. Yet, despite the expressed surprise at the strong trajectory for inflation, Powell reassured the audience that “lift-off” for rates would leave policy accommodative…just as the 2020 Policy Framework counseled them to act.

The authors reference Robert Kaplan of the Dallas Fed, a dissenter to the September 2020 forward guidance, as an early voice of caution that the Fed apparently decided to ignore. Kaplan co-authored a paper with other researchers at the Dallas Fed in May, 2021 that concluded the labor market was much tighter than indicated by traditional metrics. Eggertsson and Kohn lament that the warning “…seemed to have little effect on the official narrative of the FOMC at the time.” I am not surprised given the weak conclusion of the paper. The following quote reads like an advisory or footnote instead of a prescription or recommendation for a policy change:

“In this post, we wish to suggest that policymakers should be cognizant of a range of supply factors that may currently be weighing on employment. These factors may not be particularly susceptible to monetary policy.

We would expect that many of these factors will fade as the year progresses, increasing the number of job seekers and potentially reducing labor market tightness. However, it is also possible that labor supply will increase less than expected. It is our view that this possibility should be kept in mind as policymakers assess the appropriate stance of monetary policy.”

Note how Kaplan et al even provide an out for monetary policy to stand by and do nothing by suggesting that factors weighing on employment supply are outside the sphere of influence of monetary policy. They did not take the extra step of suggesting that monetary policy was overly accommodative given the inflationary structure of the economy. Their hints were not sufficient.

To wit, with rising speculation about the timing for rate hikes, Powell stuck his neck out in August, 2021 to issue reassurances. Whatever hawkishness hovered over the Fed evaporated in that moment. The Fed would remain focused on tapering with no implication for rates. The hints of hawkishness were simply not sufficient. They did not and could not serve as inflation control.

The focus on tapering also created drag on monetary policy. Eggertsson and Kohn pointed out that the completion of asset purchases became a prerequisite for raising rates. This condition not only resulted in an unnecessary delay but also committed the Federal Reserve to providing far-in-advance notice on how and when asset purchases would be completed.

The Labor Market Was Sufficiently Tight

As the Fed dragged its feet, the labor market tightened to historic levels. The unemployment rate did not tell the full story. Eggertsson and Kohn show how the vacancy-unemployment ratio (v/u) shot up to 0.88 by March, 20221. This level was higher than the average ratio pre-pandemic. The ratio kept climbing persistently and sharply from there. It surpassed 1 by May 2021 and went over 2 by the time the Fed finally started hiking rates in March. The vacancy-unemployment ratio was last that high during World War II. The consistent and linear increase in the first 2 years of the pandemic is truly astonishing.

Source: Eggertsson and Kohn

The authors also stress the importance of understanding the non-linearity of the Phillips curve, an economic principle that shows the relationship between unemployment and inflation. If the labor market was tight enough for these non-linearities to become quantitively significant, this “tightness of the labor market, as measured by v/u, not only gave the Federal Reserve a reason to declare it had satisfied the forward guidance of September 2020” but also indicated that failing to recognize this tightness could have been a major source of the inflation surge.

The Inflation Overshoot

By the time Powell spoke about excessive inflationary pressures in the days after the first rate hike, inflation was well into its overshoot. According to the authors, commitments to the new Policy Framework combined with the uneven and unprecedented nature of the recovery created an inflation overshoot. This inflation overshoot did not have a clear boundary due to the newly imposed condition of achieving maximum employment before raising rates. Additionally, gauging maximum employment was considerably challenging due to the uneven nature of the recovery. Traditional metrics, such as the unemployment rate, proved to be poor proxies for maximum employment under these circumstances. The Fed unwittingly locked itself into implementing the most aggressive campaign of rate hikes since the Paul Volcker days of the early 1980s.

Conclusion: Lessons Learned?

In late November, 2022, Powell claimed he learned his lessons from what I call peak deflationary thinking. In commenting during the Q&A at a Brookings Institution conference at the time, I made the following observation:

“Powell suggested that he would not repeat the ‘mistake’ of counting on the long history of low inflation as a basis for making policy. Powell noted that policy must take into consideration tail risks and their costs. Such acknowledgement forms the foundation of today’s risk management framework. However, Powell remained consistent with earlier Fed claims that starting monetary tightening earlier would not have materially impacted the path for inflation. He insisted that the mistake from two years ago has nothing to do with today’s inflation; he relegated the mistake to a footnote.”

With this attitude, the Fed is not likely to learn the lessons Eggertsson and Kohn hope the Fed takes away from this experience. Instead, the new risk going forward is that the Fed concludes the current Policy Framework just got “unlucky.”

Still, Eggertsson and Kohn are hopeful. Moving forward, they suggest that the next policy framework should be subjected to a variety of stress tests and scenarios. Also, in the next framework review, a central question should be whether the benefits hoped for by evaluating deviations of employment from its maximum level can instead be addressed by alternative tools and techniques.

Eggertsson and Kohn also explain, “Like the criteria for adjusting policy, forward guidance needs to build in flexibility in timing and sequencing to adapt to changing circumstances.” They further note that forward guidance and the policy it implies should not only focus on achieving the Federal Reserve’s goals at a particular point in time but also maintaining prices and employment around those goals after they are reached.

Perhaps ironically, these suggestions sound like a data-dependent orientation which the Fed typically professes to follow.

During his presentation, Eggertsson admitted that he was formerly on “team transitory.” A Japanese paper even interpreted him as saying that inflation was not a problem, the proverbial “there is nothing to see here.” His research and retrospective have dramatically changed his understanding and conclusions. Yet, I think he and his co-author are too charitable in claiming that “with the benefit of hindsight, we see several broad problems with the framework and forward guidance that leads to lessons learned for the future frameworks and policy execution.” Their work decisively demonstrates that the necessary signals, signs, and data were readily available for the Fed to act upon sooner. The Fed was anchored by its commitment to a Policy Framework with an inflationary bias. Going forward, policy frameworks must be much less gospel and much more responsive.

Today’s Fed is in risk management mode out of necessity. While people can endlessly debate about the risks and their quantification, this kind of circumspection is an appropriate response to this era of heightened economic uncertainty. Noble goals like driving unemployment down as low as possible in the short-term must take second seat to practical goals like sustaining long-term financial stability.

Be careful out there!

The post Why Monetary Policy Was Late In Responding to the Pandemic-Era Inflation Surge appeared first on Inflation Watch.

Kashkari’s Confessional

Kashkari sums up the Fed’s collective miss as coming from an over-reliance on traditional Phillips-curve models. These models failed the Fed for this economic cycle:

“In these workhorse models, it is very difficult to generate high inflation: Either we need to assume a very tight labor market combined with nonlinear effects, or we must assume an unanchoring of inflation expectations. That’s it. From what I can tell, our models seem ill-equipped to handle a fundamentally different source of inflation, specifically, in this case, surge pricing inflation.”

No wonder it is easy to maintain a deflationary mindset. The Philips-curve models are biased against inflationary pressures.

Refreshingly, Kashkari is not willing to accept economic shocks as an excuse for missing the seriousness of inflation in this economic cycle. Instead, he cautions that such dismissals impede learning. Moreover, he claims that even a crystal ball on inflation shocks would not have pushed the Philips-curve models to raise an inflation alarm. Since Kashkari makes this claim without evidence, I hope that someone in the Fed is working on a related white paper to advance learning on this topic.

Kashkari went on to observe that the Fed’s policy framework focuses on the labor market and inflation expectations: “If we can deepen our analytical capabilities surrounding other sources and channels of inflation, then we might be able to incorporate whatever lessons we learn into our policy framework going forward.” Yet, in April 2022, I summarized two Fed studies that identified housing as a key source of the inflation problem. At the time, I assume these studies helped guide the Fed’s determination to finally start hiking rates. I do not know how to reconcile these studies with Kashkari’s claim, but I hope he finds his way to this work at some point.

Kashkari concludes by standing firmly behind today’s monetary policy. Without a sense of irony, Kashkari defended the current monetary tightening by using wage pressures as his example.

“One may ask why tightening monetary policy is the right response to what I described as surge pricing inflation. Unfortunately, the initial surge in inflation is leading to broader inflationary pressures that the Federal Reserve must control. For example, nominal wage growth has grown to 5 percent or more, which is inconsistent with our 2 percent inflation target given recent trend productivity growth. Monetary policy is the appropriate tool to bring the labor market back into balance.”

Kashkari is also not interested in cutting rates anytime soon: “consider cutting rates only once we are convinced inflation is well on its way back down to 2 percent.” Seemingly like everyone else on the Fed, he fears the echoes from the 1970s warning that it is all too easy to declare a premature victory over inflation.

Easing Financial Conditions

If bond yields are any indication, the bond market stopped worrying about increasing inflation pressures back in October and November. For example, the iShares 20+ Year Treasury Bond ETF (TLT) not only bottomed but also it rallied 15.5% in just three months (TLT moves inversely to bond yields). Accordingly, I am eager to see whether the next announcement on monetary policy calls out the bond market for prematurely facilitating an easing in financial conditions.

The iShares 20+ Year Treasury Bond ETF (TLT) achieved a higher low at the end of December. It is close to a breakout above tis 200-day moving average (DMA) (the blue line above) which would usher in a new phase of easing of financial conditions. Is the Fed ready for that to happen? (Source: TradingView.com)

The Chicago Federal Reserve’s Adjusted Financial Conditions Index has been consistently easing since a cycle high in October.

Be careful out there!

Full disclosure: no positions

The post Kashkari Acknowledges the Fed’s Inflation Miss. Will the Fed Catch Easing Financial Conditions? appeared first on Inflation Watch.

As rates have risen, inflation expectations have declined sharply. Bullard offered the following chart to demonstrate the effectiveness of the Fed’s rush to front-load rate hikes.

Some people look at these expectations and conclude the Fed can stop before getting into the “sufficiently restrictive” zone. Some people might even conclude that Fed should start cutting rates. Most of those folks are probably focused on the stock market’s performance. Bullard instead is looking at the actual performance in the economy. GDP growth was unexpectedly strong in the second half of 2022. Even more importantly, the labor market remains very strong in aggregate as it glides through unprecedented territory. At least since 1980, the U.S. economy has never experienced such a wide gap between available jobs to the high side and available workers to the low side.

As long as this gap persists at such a magnitude, the Fed can feel comfortable about lifting rates into restrictive territory.

The Fed can declare partial victory since inflation expectations are back to previous norms. However, as Bullard noted consistently with the Fed’s messaging for months, “inflation remains too high.” If the Fed prematurely declares victory, the tightness of the labor market could become a source for reigniting inflation pressures, both real and expected.

Bullard’s words can generate out-sized market impacts. On this day, the market took Bullard’s caution pretty well. Bullard is still hawkish, but at least he is conceding some form of victory. The S&P 500’s (SPY) 1.2% loss is well within the volatility the index has experienced since it broke down below its 50-day moving average (DMA) in mid-December.

Be careful out there!

Full disclosure: no positions

The post Bullard Ready to Declare Partial Victory Over Inflation appeared first on Inflation Watch.

Bullard starts and ends with a critique familiar to those of us who insist food and energy prices should not be excluded from measures of inflation:

“One immediate benefit of dropping the emphasis on core inflation would be to reconnect the Federal Reserve with households and businesses who know price changes when they see them. With trips to the gas station and the grocery store being some of the most frequent shopping experiences for many Americans, it is hardly helpful for Fed credibility to appear to exclude all those prices from consideration in the formation of monetary policy…

…The headline measures of inflation were designed to be the best measures of inflation available. It is difficult to get around this fact with simple transformations of the price indexes. The Fed should respect the construction of the price indexes as they are and accept the policy problem it poses. To do otherwise may create the appearance of avoiding responsibility for inflation…”

(Compare and contrast this to Governor Frederic S. Mishkin’s insistence in 2007 that the Federal Reserve should care about headline inflation but focus on controlling core inflation in its public stance on monetary policy.)

I love the recognition that average consumers and businesspeople “know price changes when they see them.” This is Inflation Watch’s reporting philosophy and helps explain my emphasis on reporting the price changes of a broad range of products and services.

Bullard makes some key points to argue that headline inflation can and should be the focus of monetary policy. While I agree with his overall thesis, I do take issue with some of the points (my comments in bold):

1. Monetary policy can be adjusted to accommodate the extra volatility in headline inflation by, for example, focusing on year-over-year changes.
2. The relationship between core and headline inflation is unclear and even changes over time, making it more difficult to comprehend the optimal policy response. Me: This was an interesting point since the Federal Reserve’s statements usually imply the Federal Reserve tunes policy for core, not headline, inflation anyway. Currently, Ben Bernanke has all but absolved monetary policy of any impact on commodity prices.
3. The Federal Reserve cannot directly influence supply and demand dynamics for any particular product in the inflation index, so it is not sufficient to ignore prices that are supposedly out of the Federal Reserve’s control. Me: I understand Bullard’s point, but I also think providing cheap money that traders can easily borrow to bid up the prices of goods and services is a strong and sufficient influence. The Federal Reserve definitely thinks it can directly influence housing demand and prices given its targeted efforts at lowering mortgage rates.
4. When the price of one good goes up, another goes down as consumers adjust their demand to stay within their budgets. Increasing food and energy prices can thus force other prices down in the core index and further understate true inflation.

Bullard further notes that their is promising research into directing monetary policy at a specific subset of prices that households care most about, but it is too early to use.

Of particular interest to me was Bullard’s identification of a changing world where commodity prices will join the prices of medical care (and education) in outpacing the overall average inflation rate.

“…much of the contemporary worry about commodity prices is that relative price changes may be much more persistent going forward than they have been in the past…

…it is at least a reasonable hypothesis that global demand for energy will outstrip increased supply over the coming decades as the giant economies of Asia, particularly India and China, reach Western levels of real income per capita. If that scenario unfolds, then ignoring energy prices in a price index will systematically understate inflation for many years.”

(See “Preparing for Profits in a Resource-Constrained World” on implications for investing).

Given the limitations and blind spots of core inflation, Bullard makes a convincing case for directly targeting headline inflation with monetary policy. Otherwise, the Federal Reserve remains at risk for maintaining monetary policies that are too loose for too long.

The post Bullard recommends targeting monetary policy at headline, not core, inflation appeared first on Inflation Watch.