Via Mike O'Rourke of Jones Trading,
QE and hopes/beliefs in its perpetual nature continues to be the key market catalyst. Tracking estimates for Q2 GDP continue to drop below 1%. This is setting up a scenario where GDP for the previous 3 quarters will likely average 1%. If we didn't think that job creation is going to sustain its current pace of growth, we would say this market is heading towards the “Bearmageddon Scenario”.
There was a great deal of commentary from Fed officials last week about the Fed’s obligation to defend the inflation target from below as well as above. As usual, such statements further reinforce market doubts about the Fed’s conviction to reduce asset purchases in September. It is hard to overcome the irony embedded in current monetary policy. We are astounded that during the 3 quarters since QE Infinity has commenced, GDP's expected average is 1% and inflation as per the Fed’s preferred measure of the PCE price index is up 1% year over year. The consensus view of Central Bankers and the market expectation is to do more of the same policies that have not worked. QE3 has fallen short on job creation and GDP growth. The only inflation it has managed to create is in the prices of financial assets. Adding to the irony is the asset price inflation that has occurred in the face of market based interest rates rising (despite the Fed’s effort to prevent them).
Also gone from conversations about the environment is the historic tenet that monetary policy works with a lag. Based upon the Fed’s current promises, we will have 7 years of Zero Interest Rate Policy and $3+ Trillion in asset purchases. Regardless, despite QE’s lack of success thus far, comments about defending the inflation target only further excites markets. For a quick refresher, the Greenspan Fed adopted a 2% year over year change of PCE Price Index as an unofficial inflation target. Among the benefits the Fed cited at the time was that “The PCE chain-type index is constructed from a formula that reflects the changing composition of spending and thereby avoids some of the upward bias associated with the fixed-weight nature of the CPI.” The Bernanke Fed turned that into an official inflation target in January 2012.
The most recent reading for the PCE Price Index was 1% year over year growth in May, following 0.7% in April. The official line the Fed has taken regarding current inflation levels is that low inflation is not a concern yet. “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.” For further context, at the height of the deflationary environment in 2009, the PCE Price Index was a negative 1%.
Like most market participants, we believe outright deflation would be a severely damaging environment for the economy. That is one of the reasons we have not been overly critical of Japan for taking aggressive steps. That being said, believing or expressing a view that an economy can be micro-managed to a “specific” inflation rate (or unemployment rate) limits flexibility and creates market confusion. When inflation is within a 100 basis points of the Fed’s target either above or below, does that call for an immediate (and in today’s case) additional policy response? The chart below illustrates the PCE Price Index with 50 basis point buffers on both sides of its two percent target.
One can see that inflation was at 1% back in 1998 and early 1999 as markets and the economy ripped. Many would argue the additional Fed easing that occurred in late 1998 due to Long Term Capital Management’s failure helped fuel the equity bubble. The other episodes of low inflation were during the 2001 and 2008 recessions. There were several times inflation was well above target during both the Greenspan and Bernanke years, even during the current recovery. As inflation approached 3% in 2011, the Fed was still in the midst of QE2. Obviously, tightening then would have been a mistake.
Another important fact helping fuel the current low inflation is that Energy prices have remained relatively well behaved. June and July readings will not have that benefit. We know that is not the case, but the way some Fed officials are talking they might be happier if the public were paying higher energy prices because it boosts their preferred metric. In addition to the PCE Price Index, the Fed also looks at the Core PCE Price index as well as the CPI, PPI and their respective core readings. The chart below illustrates the Core PCE Price Index, which excludes Food and energy due to their volatility.
When compared to the headline index, one can see that food and energy are the key drivers of the extreme moves. As such, the Fed has traditionally ignored the inflationary signal they create. Enforcing the upper bound of the headline index in 2004-2005 may have preempted much of the bad behavior that followed. That is an example of not enforcing the target when it would have helped.
As noted earlier, the Fed sacrifices flexibility with a formal target. There are obviously times in the past when enforcing it would have been a mistake. There are also times when not enforcing it was likely a mistake. This is Central Banker hubris, believing they can fine tune an economy to specific inflation and unemployment levels only serves as a distraction to markets. If history is a guide, it is highly probable that it won’t ever be enforced in a consistent manner. The Fed has already exhibited that it will not enforce on the upside, but to no avail is aggressively trying to enforce it on the downside.