The markets are not scared of inflation, they are scared of the Fed

The Fed, it seems, has regressed to a New-Keynesian mindset.  Despite employing reams of Finance professionals it still doesn’t understand the concept of informational efficiency.

The key to fighting inflation is to manage expectations.  Exactly how expectations are formed determines policy.  The New-Keynesian way is ‘adaptive’ – that is economic agents extrapolate from the latest CPI print and that’s that.  The New-Keynesian way is backward looking and economic agents systematically make errors by forming expectations in this way.

The Finance way is to look forward and come up with a best guess of the future using all available information.   The Finance way is couched in the language of informational efficiency and is often called ‘rational expectations ‘ in the economics world.  Rational expectations stokes the class war between New-Classical and New-Keynesian economists but no-one would dispute that financial markets operate in this way and no-one disputes that financial professionals spend their lives dealing with uncertainty in the best way they can. 

Active New-Keynesian policy making, however, relies on adaptive expectations to justify itself.  If the CPI prints at 8% then the assumption is that inflationary expectations are 8% and that the Fed needs to raise interest rates above 8% to beat those expectations lower. But how can the 10 year bond rate be just 3.4% if inflationary expectations are 8%?  Clearly the financial markets do not believe the New-Keynesian story and any price spike will not propogate itself into an 8% inflation rate. 

The Fed has indicated that it will do everything it needs to control the inflation rate.  Those needs depend on expectations.  The Finance approach leads to a super-neutrality of money result which means that interest rates don’t need to rise to control inflation.  In fact, the CPI print is recording changes in relative prices rather than inflation.  The New-Keynesian approach is quite irresponsible, actually, since it risks leading the Fed into a highly restrictive and economically damaging policy of extreme rate rises only to be met with the future of benign inflation outcomes that the financial markets are predicting.

The stock market’s fall in response to the CPI reflects concern about the Fed’s policy.  Put simply, the financial markets are not scared of inflation.  They are scared of the Fed.