The Federal Reserve announced a new policy approach today. Instead of focusing on forward looking inflation metrics they will now base monetary policy on backward looking inflation measures. This is interesting given the history of monetary policy. I recall in graduate school over 30 years ago that a major criticism of the Fed’s implementation was that they were always reacting to economic events. They compounded problems by not being proactive enough. In the jargon of the day they were too procyclical when they should be just the opposite. Eventually, they altered policy to be more forward looking. Now they have again returned to a reactionary policy. They will wait until actual realized inflation rises above 2% in a sustained way. It is unclear what inflation measure they will use or how they will quantify sustained, but does it really matter? It just allows the Fed to retain a ridiculously accommodative and reckless policy going for longer.
What all of this really illustrates is how ill equipped the Fed is in understanding economics. They have single handedly destroyed the capital markets and thus the economy. The flooding of capital into the markets has perverted how the economy reacts to their actions. Monetary policy over the past decade, and particularly the last six months, has forever changed the way the economy operates. By inserting themselves so aggressively they have altered consumer behavior and spending to a point where the Fed no longer has any idea how the economy works. Now, with the extraordinary glut of capital, and a society living in fear, they have thrown in the towel completely and effectively given up on how proper monetary policy should be implemented. They realize that they, together with other central banks, have permanently altered the level of inflation. Don’t be surprised if in the near future they create new definitions of how inflation is measured in order to never hit the 2% level. After all, if the central banks can be forever accommodative, wouldn’t that be what’s best for the capital markets? In the end that’s who has been running the Fed since 2009 anyway. Now it is just pretend. The risk of course is what happens when inflation does return (regardless how it is measured). Can the Fed even operate properly at that point to implement any kind of monetary policy? The Fed’s balance sheet will be so leveraged they may never be able to properly deal with inflation ever again.
Another interesting aspect of this new policy is how exactly do they implement raising rates? Will they simply match actual inflation above 2% in .25% increments? So, if actual inflation is between 2 and 2.25% they increase the target by .25%? What if inflation suddenly increases as a result of pent up demand, say it jumps to 4%? Do they increase the target by 2% suddenly? This would shock the market. They are creating the potential for an implementation nightmare. I doubt that the folks at the Fed have bothered to even think about that. Most will be gone and be working for a large sell-side bank by that time or have tenure at some academic institution. The long term matters little. It’s all about now. They are desperately trying to throw everything at the markets they can, hoping they can buy time until organic growth emerges. It is a dangerous gambit and one that may end badly. Hail Mary passes rarely work.
Source: The New Yorker.
The upside of this new approach is that they have created a very easy way for everyone in the market to predict when policy will switch from accommodative to restrictive. Below we have plotted the annualized change in inflation as measured by the CPI, the corresponding 12-month moving average, and the 2% trigger level. The data are from FRED. Since inception the annualized change in CPI has averaged over 3.33% and the moving average has averaged 3.38%. This makes one wonder where 2% came from! However, since 2000 each has averaged 2.08% and 2.12% respectively. Using the MA as a proxy for our new monetary policy, the Fed should have been in a restrictive mode approximately 8 times in the past 20 years, and four times since 2010. Interestingly, amidst full QE the Fed would have been in a restrictive mode using the new policy criterion. How will they negotiate this kind of discrepancy going forward? Our bet is that they will redefine the metric, alter the 2% since it is somewhat arbitrary anyway, or play around with quantifying “sustained”. Maybe even all three! After all, they are trying to reduce operational constraints with this latest change not increase them, so expect some revising going forward.
The new approach will more than likely not amount to much other than furthering evidence that the Fed has completely lost all credibility. They simply do not understand how the economy works. A day will arrive when the markets realize that the Fed is simply incapable of fulfilling their true mandate. By that time, the Fed’s balance sheet will be impossibly leveraged and it will make Lehman look downright risk averse by comparison. Political appointees are following their directive of trying to save the economy in the short run at all costs. By doing so they have destroyed the fixed income markets possibly forever and have so distorted how basic economic forces have historically worked. Now they have no idea what they are doing. By returning to a completely reactive and procyclical framework they have gone back to the future. If they continue to insert themselves into the markets, this new mandate will not amount to much because it won’t be implementable. It would be nice if they removed themselves from the markets and then had a transparent decision criterion like that proposed. Unfortunately, that serves our purpose as investors, not theirs as self-serving political appointees and so it will never happen.