The Fed and Its Fictions

I woke up this morning and, as I usually do, checked the US market action via the Wall Street Journal app. Stocks were up, not surprisingly…because of the Fed, not surprisingly. But the funny thing was the headline, obviously written by someone completely bored and out of ideas by this Fed dominated market.

‘US Stocks Climb’, it read.

Clearly, the headline writer at the Journal has lost their enthusiasm for markets in the late northern summer.

To be honest, I don’t blame them.

Yes, the reason for the market’s rise was yet another Fed statement.

But today, let me give you a different take on it to the one you’ll read all over the mainstream media.

Firstly, what’s going on?

Well, Fed boss Jay Powell made a speech overnight at the virtual Jackson Hole conference, an annual get-together for central bankers. CNBC summarises it well:

The Federal Reserve announced a major policy shift Thursday, saying that it is willing to allow inflation to run hotter than normal in order to support the labor market and broader economy.

In a move that Chairman Jerome Powell called a “robust updating” of Fed policy, the central bank formally agreed to a policy of “average inflation targeting.” That means it will allow inflation to run “moderately” above the Fed’s 2% goal “for some time” following periods when it has run below that objective.

The changes were codified in a policy blueprint called the “Statement on Longer-Run Goals and Monetary Policy Strategy,” first adopted in 2012, that has informed the Fed’s approach to interest rates and general economic growth.

As a practical matter, the move means the Fed will be less inclined to hike interest rates when the unemployment rate falls, so long as inflation does not creep up as well. Central bank officials traditionally have believed that low unemployment leads to dangerously higher levels of inflation, and they’ve moved preemptively to head it off.

This is just more theatre, the theatre of the absurd.

The Fed is (still) trying to convince everyone that it can create inflation, and that it is prepared to do so.

It’s rubbish. The only inflation the Fed creates is in asset markets. The real economy, in large part due to Fed policy, is broken beyond repair. That’s why we’ve been in a deflationary economy ever since the GFC, broken only by occasional hopes of a return to inflationary growth.

Ever since 2008, global central banks have engaged in ‘quantitative easing’ to varying degrees. You can see it in the chart below:


Port Phillip Publishing

Source: Yardeni Research

[Click to open in a new window]

The major central bank balance sheets have gone from just over US$3 trillion at the start of 2007 to US$21 trillion now.

Where’s the inflation?

Exactly.

This balance sheet expansion is merely an attempt to offset the deflationary forces emanating from a broken real economy. That’s why this activity hasn’t produced inflation.

But don’t worry, says Jay Powell, it will…

From his statement overnight (with my emphasis added):

Our new statement explicitly acknowledges the challenges posed by the proximity of interest rates to the effective lower bound. By reducing our scope to support the economy by cutting interest rates, the lower bound increases downward risks to employment and inflation. To counter these risks, we are prepared to use our full range of tools to support the economy.

Ohhh…so they haven’t yet used their full range of tools to support the economy?

But they are prepared to.

Right…

In that statement, Powell implicitly recognises the risk of deflation. The ‘lower bound’ refers to the fact that nominal rates can only go to zero. That’s why the ‘lower bound increases downward risks to employment and inflation’.

Despite all the bluster, long-term inflation expectations remain weak. The 10-year inflation breakeven rate is just 1.72%. The market is saying that over the next 10 years, inflation will average 1.72%. For all the fiscal and monetary stimulus we’ve seen recently, the bond market is yawning.


Port Phillip Publishing

Source: St Louis Fed

[Click to open in a new window]

In saying that, inflation expectations have picked up. When the COVID panic hit, long-term inflation expectations plunged to nearly 0.4%. But following the fiscal and monetary response, as well as the realisation that the virus is not as bad as our leaders are trying to tell us, things turned around.

And they could be heading higher still. But it’s only getting back to where it was before COVID hit, and well off the highs reached in 2018.

But don’t tell the stock market any of this. There is no more willing believer of the Fed’s inflationary fiction than the stock market.

In some sense, markets are ALL about belief. Belief is the thing that divorces stock prices from their fundamental values. And right now, the ‘inflation is coming’ narrative is alive and well.

How long it lasts is anyone’s guess.

But I do know that it is nothing more than a fiction.

Regards,

Greg Canavan Signature

Greg Canavan,
Editor, The Rum Rebellion


Greg Canavan approaches the investment world with an ‘ignorance is bliss’ philosophy. In a world where all the information is just a click away at all times, Greg believes we ingest too much of it. As a result, we forget how to think for ourselves, and let other people’s thoughts cloud our own.

Or worse, we only seek out the voices who are confirming our biases and narrowminded views of the truth. Either situation is not ideal. With regards to investing, this makes us follow the masses rather than our own gut instincts.

At The Rum Rebellion, fake news and unethical political persuasion are not in the least bit tolerated. It denounces the heavy amount of government influence which the public accommodates.

Greg will help The Rum Rebellion readers block out all the nonsense and encourage personal responsibility…both in the financial and political world.

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