By Eric Peters, CIO of One River Asset Management
The Fed Listens
"The independence of monetary policy is bestowed by elected officials,” said Indiana, the market’s top archeologist. “The inflection point we are seeing today is the inverse of Volcker’s 1979, with the punitive nature of inflation a distant memory,” he said. “Before Volcker’s slaying of inflation was the recognition that inflation was a political problem. The people and by extension the politics demanded inflation be tamed. The Federal Reserve responded. Carter’s nationally televised address in October 1978 captured the moment. The political fallout from inflation was readily apparent in that address.”
“Good evening. I want to have a frank talk with you tonight about our most serious domestic problem,” said President Carter in an October 1978 televised address. “That problem is inflation. Inflation is obviously a serious problem. What is the solution? One of these answers is to impose a complicated scheme of Federal government wage and price controls on our entire free economic system. The other is a deliberate recession which would throw millions of people out of work. Both of these extreme proposals would not work, and they must be rejected.”
"Each time is different yet history rhymes,” continued Indy, flipping through maps, texts, ancient market manuscripts. “There was a tug-of-war between Powell and market expectations heading into the March FOMC meeting – torn between lessons from recent cycles and those from longer history,” he said. “Powell was in the hot seat of balancing market expectations for an earlier rate liftoff with a forceful explanation about why and how this time is different. Context is key. The Fed took 14 stops on its ‘Fed Listens’ series with the objective of revising the strategic goals of monetary policy."
“The changes may seem subtle. But the undertones are powerful,” explained Indiana. “Political winds shift monetary policy. Half of the ‘Fed Listens’ events were with community leaders. The strategic statement revised the employment goal to emphasize breath and inclusion, a point of emphasis in Powell’s Feb testimony to Congress,” he said. “And the FOMC ‘dots’ illustrated the point. Even with the unemployment rate falling below 4% next year and inflation above the 2% target, policy rates are expected to be at emergency levels through 2023.”
“In the next five years, real interest rates are expected to remain steeply negative; market-traded real yields are –1.7%,” said Indy. “The bond market still sees an earlier liftoff in policy rates, but it is splitting hairs. The Fed is signaling steeply negative real rates and the market is accommodating that guidance. The surprise is thereafter. Real interest rates in the subsequent five years are expected to rise sharply to +0.6% on average. Likewise, the bond market sees inflation overshooting to 2.5% in the next five years, and a perfect landing back to 2% in the following five years. The market narrative is that the Fed knows how to tame inflation. But the issue will be far more complicated than a stochastic simulation.”
"Policy is committed to being steeply backward looking at a time when the goods sector is already overheating,” added Indy. “The details of the PMI surveys are a useful benchmark. There are more than 60 commodity inputs to production that are monitored by prices and supply. Only one was reported down in Feb (dairy) and the list of commodities in short supply is growing, including semiconductors for the past three months. Delivery times are slow and across industries the anecdotes are focused on shortages: ‘Supply chains are depleted; inventories up and down the supply chain are empty. Lead times increasing, prices increasing, [and] demand increasing.’"
"The lights will be back on in the service sector soon enough,” said Indy, wrapping up. “At the end of Feb, 18.2mm Americans were collecting unemployment support, the majority through new Federal programs. Record fiscal and monetary stimulus is geared to supporting this cohort. The hope/expectation is for a rapid return to the workforce. Inflation overshooting is assured. The biggest question for individuals and asset allocators – who is the beneficiary cohort of higher inflation and how will they respond to it?” asked Indy, rhetorically, because of course, the beneficiaries of higher inflation are those who create it - the politicians.