Powell on Inflation
Doug Nolan
The spike in Treasury yields runs unabated. Ten-year Treasury yields rose another 10 bps this week to 1.72%, the high since January 23, 2020.
The Treasury five-year “breakeven” inflation rates rose to 2.65% in Tuesday trading, the high since July 2008.
The Philadelphia Fed’s Business Survey Prices Paid Index surged to a 41-year-high.
In the New York Fed’s Manufacturing Index, indices of Prices Paid and Received both jumped to highs since 2011.
While crude oil’s notable 6.4% decline for the week spurred a moderate pullback in market inflation expectations (i.e. “breakeven rates”), this did not translate into any relief in the unfolding Treasury bear market.
Chairman Powell was widely lauded for his adept handling of Wednesday’s post-FOMC meeting press conference.
He was well-prepared and could not have been more direct: The Federal Reserve will not anytime soon be contemplating a retreat from its ultra-dovish stance.
It was music to the equities mania, as the Dow gained 190 points to trade above 33,000 for the first time.
Treasury yields added a couple bps, but without any of the feared fireworks. Markets were breathing a sigh of relief.
Labored breathing returned Thursday.
Ten-year Treasury yields spiked another 10 bps, trading above 1.75% for the first time since January 2020.
And after trading as low as 0.76% during Powell’s press conference, five-year Treasury yields spiked to almost 0.90% in increasingly disorderly Thursday trading.
The Nasdaq100 was slammed 3.1%, with the S&P500 sinking 1.5%.
The Treasury market would really like to take comfort from the Fed’s steadfast dovishness.
It’s just been fundamental to so much.
It’s worked incredibly well for so long.
Clearly, it’s no longer working so well.
This raises a critical issue: Paradigm shift?
Regime change?
What’s driving Treasury yields these days?
What is the bond market fearing?
If it’s inflation, is Fed dovishness friend or foe?
March 16 – Financial Times (Joshua Oliver):
“Coronavirus has been overtaken for the first time since the early days of the pandemic more than a year ago as the top risk that keeps investors up at night, according to a new poll of fund managers.
Money managers polled by Bank of America now see inflation and an unruly rise in borrowing costs like that seen during the 2013 ‘taper tantrum’ as the key ‘tail risk’ that could unsettle global markets.
The survey of investors with $597bn in assets… highlights investors’ concern that the economic recovery from Covid-19, backed by unprecedented stimulus, may unleash a surge of price growth that could be difficult to tame.
Rising inflation expectations and bets that central banks, particularly the US Federal Reserve, may have to tighten policy sooner than planned have triggered a widespread sell-off in government bond markets — which investors worry could get worse.”
For the first time in years, bond markets face serious uncertainty with respect to inflation risk.
The Fed’s balance sheet has doubled in only 79 weeks to $7.694 TN.
Our Federal government is in the process of running consecutive years of $3.0 TN plus deficits.
Chinese Credit (“aggregate financing”) expanded an unprecedented $5.4 TN last year and then added another Trillion in the first two months of 2021.
On an unprecedented global basis, central bank balance sheets are expanding aggressively, while unbridled governments are running massive deficit spending programs.
Forecasts are calling for upwards of 8.0% U.S. 2021 GDP growth, with an only moderately slower Chinese expansion.
While the global economy is poised for recovery, it’s not at all clear governments will muster the resolve necessary to pull back meaningfully from unparalleled fiscal and stimulus.
The world has never experienced such monetary inflation.
Long-term fixed-income securities have ample reason to fear a paradigm shift in inflation dynamics.
And in this unfolding new environment, I don’t think the old “err on the side of ultra-dovishness” shtick is going to suffice.
I found the Powell press conference problematic.
After less than glorious market responses to his recent congressional testimony and WSJ Q&A session, I would have thought some tinkering of his messaging was in order.
But Powell doubled down.
No tapering or a move on rates is being contemplated – and the Fed will be providing ample warning well ahead of time.
The FOMC is not concerned by what it views as a fleeting pop in inflation.
It’s now well dug into its bunker mandate of promoting full employment, while mouthing - and praying for - price stability.
Paul Kiernan from the Wall Street Journal (from Powell’s press conference):
“My question is twofold.
One, how high are you comfortable letting inflation rise?
There is some ambiguity in your new target, as you mentioned - expectations driven.
And do you think that that ambiguity might cause markets to price in a lower tolerance for inflation than the Fed actually has, thereby causing financial conditions to tighten prematurely?
Is that a concern?”
Fed Chairman Jay Powell:
“So, we’ve said we’d like to see inflation run moderately above 2% for some time.
And we’ve resisted, basically, generally, the temptation to try to quantify that.
Part of that just is talking about inflation is one thing.
Actually having inflation run above 2% is the real thing.
So, over the years, we’ve talked about 2% inflation as a goal, but we haven’t achieved it.
So, I would say we’d like to perform.
That’s what we’d really like to do is to get inflation moderately above 2%.
I don’t want to be too specific about what that means, because I think it’s hard to do that.
And we haven’t done it yet.
When we’re actually above 2%, we can do that.
I would say this: the fundamental change in our framework is that we were not going to act preemptively based on forecasts, for the most part. And we’re going to wait to see actual data.
And I think it will take people time to adjust to that.
And to adjust that new practice. And the only way we can really build the credibility of that is by doing it.
So, that’s how I would think about that.”
Noland comment:
The Fed picked an especially poor time to go rouge on inflation management.
And this will not be the backdrop for Fed credibility to be on the ascend.
With all the lip service paid to transparency, the Fed today cannot clarify its reaction function – what inflationary developments would spark concern at the FOMC as well as the measures the Fed would employ to counter mounting inflationary pressures.
The Chair doesn’t “want to be too specific” because the FOMC doesn’t have a framework or a plan.
Their latest experimental iteration – the adoption of an “inflation targeting” regime – was basically to ensure they retained the flexibility to remain ultra-dovish while disregarding their inflation target in the event of a breach above 2%.
I doubt they ever contemplated how the committee would respond to a serious threat of entrenched inflationary pressures.
No one believes the Fed will actually tighten policy.
Michael Derby from the Wall Street Journal:
“I just wanted to get an updated view on your sense of your view on financial stability risks, and whether or not you see any pockets of excess out in financial markets that concern you either specifically to that area of the market or as in terms the threat that it can pose to the overall economy?”
Powell:
“As you know, financial stability for us is a framework.
It’s not one thing. It’s not a particular market or a particular asset or anything like that.
It’s a framework that we have.
We report on it semiannually.
The board gets a report on it quarterly.
And we monitor it every day.
It has four pillars. And those are four key vulnerabilities: asset valuations; debt owed by businesses and households; funding risk; and leverage among financial institutions.
Those four things, and I’ll just quickly touch on them.
If you look at asset valuations, you can say that by some measures some asset valuations are elevated compared to history, I think that’s clear.
In terms of households and businesses, households entered the crisis in very good shape by historical standards.
Leverage in the household sector had been just kind of gradually moving down and down and down since the financial crisis. Now, there was some negative effects on that.
People lost their jobs and that sort of thing.
But they’ve also gotten a lot of support now.
So, the damage hasn’t been as bad as we thought.
Businesses, by the same token, had a high debt load coming in.
Many saw their revenues decline.
But they’ve done so much financing, and there’s a lot of cash on their balance sheet.
So, nothing in those two sectors really jumps out as really troubling.
Short-term funding risk as the last one.
We saw, again, in this crisis, breakdowns in parts of the short-term funding markets - came under a tremendous amount of stress.
And they’ve been quiet since the spring, and we shut down our facilities and all that.
But we don’t feel like we can let the moment pass without just saying, again, that some aspects of the short-term funding markets – and more broadly nonbank financial intermediation – didn’t hold up so well under great stress - under tremendous stress.
And we need to go back and look at that.
So, a very high priority for us, as regulators and supervisors, is going to be to go back – this will involve all the other regulatory agencies.
It does involve all of them… and see if we can strengthen those things.
So, that’s a sort of a broader detailed look.”
Noland comment:
This topic is worthy of a lengthy book.
The Fed exhausts too much energy rationalizing its “full employment” and “stable prices” mandates, while neglecting it overarching responsibility to safeguard financial stability.
Similar to its analytical approach to inflation, the Fed lacks a sound financial stability framework.
“You can say that by some measures some asset valuations are elevated compared to history,” while a historic mania rages in equities, corporate Credit, ETFs, cryptocurrencies, NFT (“non-fungible tokens”), collectibles and such.
The Fed’s focus on household and corporate balance sheets needs to be supplanted by a more holistic approach to system finance.
Treasury Securities have increased $17.55 TN, or almost 300%, since the end of 2007, with combined Treasury and Agency Securities up $20.3 TN.
Over this period, the Fed’s balance sheet has inflated $6.7 TN, or over 700%.
This unprecedented increase in government Credit has (almost singlehandedly) inflated incomes, asset prices and Household Net Worth.
For the corporate sector, massive government monetary inflation has boosted cash-flows and earnings, while stoking loose financial conditions and associated gains to corporate equity and financing costs.
Any legitimate analysis of financial stability must focus on profligate government finance while downplaying deceptive stability in the household and corporate sectors.
The Fed’s analytical framework is a contraption of the last war.
The mortgage finance Bubble was chiefly fueled by a massive increase in household mortgage borrowings intermediated through the GSEs, the banking system, and securitization and derivatives marketplaces.
All these sectors were heavily exposed to the bursting Bubbles in mortgage finance and housing.
Today’s “government finance Bubble” is fueled chiefly by government debt and Federal Reserve liabilities.
This perceived safe and liquid “money”-like Credit requires minimal risk intermediation through the banking system or markets.
As such, the nature of the risks to financial stability are different in kind to those of mortgage Credit.
Superficially, the banking system today appears well-capitalized and robust.
From the prism of 2008, financial institutions more generally do not appear over-levered or heavily exposed to risky Credit.
“We saw, again, in this crisis, breakdowns in parts of the short-term funding markets - came under a tremendous amount of stress.”
Meanwhile, the government finance Bubble has spurred myriad and monumental “funding market” risks.
For one, massive monetary inflation has fueled market manias, egregious speculation and unprecedented speculative leverage.
This ensures illiquidity and dislocation in the event of any meaningful “risk off” de-risking/deleveraging episode.
Zero rates and the search for yield have fomented speculative excess, leverage and epic market distortions – at home and internationally.
Risk perceptions have been entirely subverted, from the standpoint of the Fed backstopping the securities markets and Washington, more generally, underpinning the U.S. Bubble Economy.
In particular, I would point to the proliferation and incredible popularity of ETF products and associated inevitable liquidity issues as integral to this Bubble cycle’s unique risks to financial stability.
The perception of safety and liquidity (“moneyness”) is fundamental to the widespread adoption of ETF products.
As we witnessed again last March, when this misperception of moneyness is exposed, these products immediately become vulnerable to dislocation, panic and “investor” runs.
From a financial stability standpoint, the Fed should be extremely concerned by Bubble Dynamic risk misperceptions and accumulating excesses and imbalances.
Yet the Fed’s repeated market bailouts only solidify precarious market distortions while exacerbating the risk of a market crash.
During the mortgage finance Bubble period, a “moneyness of Credit” dynamic was fundamental to market mispricing and risk distortions.
Increasingly risky mortgage Credit was transformed into perceived safe and liquid “AAA” mortgage securities, allowing a prolonged period of Credit and risk intermediation excesses to impart deep structural impairment.
When Ben Bernanke slashed rates to zero, adopted QE, and forced savers into the securities markets, I warned of a “moneyness of risk assets” dynamic.
More than a decade of historic market intrusions have created a major threat to financial stability.
A crisis of confidence and run on perceived safe securities appears unavoidable, and this threat has inflated profoundly following a year of egregious monetary inflation and market manipulation.
And while “leverage among financial institutions” is an area of Fed focus, from a financial stability standpoint I would argue that speculative leverage throughout global markets these days creates preeminent risk for a market crash, vanishing perceived wealth, and a resulting devastating tightening of financial conditions.
The perceived “moneyness” of government Credit – along with the willingness to recklessly expand the Fed’s and federal government’s liabilities ad infinitum – creates a unique capacity to finance a most prolonged Bubble period.
This ensures the deepest of structural impairment, along with devastating consequences come the inevitable crisis of confidence in government finance and policymaking.
Michael McKee from Bloomberg:
“Before 2019 you were focused on the problems with having interest-rates too low.
Now are you saying we’re willing to live with it until we reach these goals, even if you hit your goal on maximum employment?”
Powell:
“What I would say is we’re committed to giving the economy the support that it needs to return as quickly as possible to a state of maximum employment and price stability.
And to the extent having rates low and support for monetary policy broadly - to the extent that raises other questions, we think it’s absolutely essential to maintain the strength and stability of the broader financial system and to carefully monitor financial stability questions…
We monitor that very carefully. I would point out that over the long expansion - longest in U.S. history; 10 years and eight months - rates were very low.
They were at zero for seven years, and then never got above 2.4%, roughly.
During that we didn’t see, actually, excess buildup of debt.
We didn’t see asset prices forming to bubbles that would threaten the progress of the economy.
We didn’t see a housing bubble.
The things that have tended to really hurt an economy - and have in recent history hurt the U.S. - we didn’t see them build up despite very low rates.
Part of that just is that you’re in a low rate environment.
You’re in a much lower rate environment, and a connection between low rates and the kind of financial instability issues is just not as tight as people think it is.
That’s not to say we ignore it.
We don’t ignore it.
We watch it very carefully.
And we think there is a connection.
I would say there is, but it’s not quite so clear.
We actually monitor financial conditions very, very broadly and carefully.
And we didn’t do that before the global financial crisis 12 years ago.
Now we do.
And we’ve also put a lot of time and effort into strengthening the large financial institutions that form the core of our financial system - are much stronger, much more resilient.
That’s true of the banks.
I think it’s true of the CCPs (central counterparties). We want it to be true of other non-bank financial intermediation markets and institutions.
Monetary policy should be, to me, provided for achieving our macroeconomic gains.
Financial regulatory policy and supervision should be for strengthening the financial system so that it is strong and robust and can withstand the kind of things that it couldn’t, frankly.
And we learned that in 2008, ’09, ‘10.
This time around, the regulated part of the financial system held up very well.
We found some other areas that need strengthening, and that’s what we’re working on now.”
Noland comment:
I abhor historical revisionism.
“Rates were very low.
They were at zero for seven years… During that we didn’t see… excess buildup of debt.
We didn’t see asset prices forming to bubbles…
We didn’t see a housing bubble.”
When it comes to an excessive buildup of debt, I would direct Chairman Powell to his institution’s quarterly Z.1 reports.
U.S. Non-Financial Debt (NFD) ended 2007 at $33.4 TN (230% of GDP).
It closed out 2020 at $61.167 TN, or a record 292% of GDP.
After ending ’07 at $8.1 TN (55% of GDP), Treasury Liabilities surged $18.4 TN, or 228%, to $26.4 TN, or a record 123% of GDP.
And perhaps a comparable buildup of debt would be associated with “carry trades,” derivative-related leverage, margin debt, and myriad forms of speculative leverage.
Why did the Fed abandon its 2011 “exit strategy” – moving instead to again double its balance sheet in three years to $4.5 TN?
Why was the Fed so petrified by “taper tantrums” and “flash crashes”?
Why in 2013 was Bernanke compelled to assure the market the Fed would “push back against” a tightening of financial conditions, essentially signaling the Federal Reserve would not tolerate a pullback in equities prices?
After one little baby-step off the zero bound in December 2015, why did the Yellen Fed then put rate “normalization” on hold for a full year?
And, Mr. Chairman, why did you so abruptly pivot back to dovishness in response to market instability back in December 2018?
And why a year later would the Fed restart QE despite stocks at record highs and unemployment at multi-decade lows?
Moreover, why in 2020 was the Fed forced to resort to in excess of $2.5 TN of QE over an about two month period – and then stick with $120 billion liquidity injections despite securities market recovery and conspicuous signs of a full-fledged mania?
Why today such resolve to signal ultra-dovishness?
Clearly, the Fed has for years understood the risks associated with piercing market Bubbles.
Don Lee from the Los Angeles Times.
“As you know, households are sitting on a lot of excess savings.
And I wonder if combined with that you have an unleashing of pent up demand, how much do you think that would affect inflation?
And would you expect that to be transitory?”
Powell:
“We, everyone who’s forecasting these, what we’re all doing is we are looking at the amount of savings - we have reasonably good data on that.
And we’re looking at the government transfers that will be made as part of the various laws.
And we’re trying to make an assessment on what will be the tendency of people to spend that money, the “marginal propensity to consume”.
And from that you can develop an estimate of the impact on spending, on growth, on hiring, and, ultimately, on inflation.
So that’s what we’re all doing.
And we can look at history, and we can make estimates, and those are all very transparent and public, and you can compare one to the other.
And, of course, we’ve all done that.
And I think we’ve made very conservative assumptions, and sensible mainstream assumptions at each step of that process.
And what it comes down to… is there very likely will be a step up in inflation as March and April of last year dropped out of the 12-month window, because they were very low inflation numbers.
That’ll be a fairly significant pop in inflation.
It will wear off quickly though, because it’s just the way the numbers are calculated.
Past that, as the economy reopens, people will start spending more.
You can only go out to dinner once per night, but a lot of people can go out to dinner.
They’re not doing that now.
They’re not going to restaurants; not going to theaters.
That part of the economy - travel and hotels - that part of the economy is really not functioning at full capacity.
But as that happens, people can start to spend.
It also wouldn’t be surprising if - and you’re seeing this now particularly in the goods economy – there’ll be bottlenecks.
They won’t be able to service all of the demand, maybe for a period.
So, those things could lead to - and we’ve modeled that, other people have to - and what we see is relatively modest increases in inflation.
But those are not permanent things.
What will happen is the supply side - the supply side in the United States is very dynamic - people start businesses, they reopen restaurants, the airlines will be flying again.
All of those things will happen.
And so, it’ll turn out to be a one-time sort of bulge in prices.
But it won’t change inflation going forward.
Because inflation expectations are strongly anchored around 2%.
We know that inflation dynamics do evolve over time.
There was a time when inflation went up it would stay up.
And that time is not now.
That hasn’t been the case for some decades.
And we think it won’t suddenly change to another regime.
These things tend to change over time, and they tend to change when the central bank doesn’t understand that having inflation expectations anchored at 2% is the key to it all.
Having them anchored at 2% is what gives us the ability to push hard when the economy is really weak.
If we saw inflation expectations moving materially above 2%, of course, we would conduct policy in a way that would make sure that that didn’t happen.
We’re committed to having inflation expectations anchored at 2%, not materially above or below 2%.
So, if you look at the savings, look at all of that, model it, that’s kind of what comes out of our assessment.
There are different possibilities.
I think it’s a very unusual situation to have all these savings, and this amount of fiscal support and monetary policy support.
Nonetheless, that is our most likely case.
As the data come in and the economy performs, we’ll of course adjust.
Our outcome-based guidance will immediately adapt, we think, to meet whatever the actual path of the economy is.”
Noland comment:
Powell’s response to this inflation question is near the top of my list of why I disagree with the consensus view of a successful press conference.
I’ll cut the Fed Chair some slack.
He’s not a trained economist, while consumer price inflation has been rather subdued now for three decades.
But I don’t think his rudimentary explanation of why inflation is not a concern is going to suffice.
There is no consideration for the monumental shift to massive open-ended central bank monetary inflation on a global scale.
No mention of the structural shift to colossal fiscal deficits and spending – again globally.
How could such unleashing of government finance not impact global inflation dynamics?
In Powell’s assessment there was no recognition of spiking global food prices.
How can one have a thoughtful discussion about inflation prospects without recognizing myriad risks associated with global climate change?
Future historians will look back to pandemic year 2020 as an inflection point of far-reaching consequence.
It started with hording toilet paper.
Now a global semiconductor shortage has entire industries scurrying to procure needed components.
All types of supply chains have been disrupted.
There are bottlenecks galore, and various shipping and transport channels are suffering disruptions and delays.
From vaccines, to PPE, to semiconductors, shipping containers, rare earth metals, to food supplies and much beyond, I expect a major shift to nations taking pains to become more self-sufficient.
Households, businesses and countries will hold more of many things in reserve.
Hording – from foodstuffs to rare earths to semiconductors – is in.
Just in time inventory management is out.
The prolonged Bubble period has greatly exacerbated wealth inequality.
The inevitable swinging back of the pendulum has begun.
Wealth redistribution policies will see mammoth transfer payments along with higher wages.
And as our nation moves toward massive investments in renewable energy and to upgrade neglected infrastructure, the momentous change in the flow of finance from the asset markets to real economy investment will further promote a transformation of inflation dynamics.
Risks to the inflation outlook are real.
The odds that we are at the precipice of a major shift in inflation dynamics are not low.
At the same time, the Fed is completely unprepared – both intellectually and from a policy perspective.
Historic Bubbles have left the Federal Reserve lacking flexibility and objectivity: it will doggedly dismiss inflation risk and hope for the best.
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