Spurious Fed policy
A lower than expected CPI result of +0.4% for October in the US sparked an explosive rally across risk assets last night. If this number propogates for the next year then the Fed is finished tightening. If the number continues to fall then the Fed will be led to reverse course. Interest rate dependent securities such as bonds rose big time. High yield bonds, for instance, were up 3%. Non-interest rate sectors rose big time. The tech-heavy NASDAQ rose 7%, for instance. Put simply, everything rose big time indicating that the Fed is the major directional factor driving markets at present.
Should Fed policy be where it is? I have argued previously that, with rational expectations a feature of the markets, the Fed should not be raising rates as aggressively as it has done. In fact, the subsidence of the inflationary threat that is peeping through in last night’s data was anticipated by the bond market as evidenced by an inverted yield curve. The Fed is operating in a backward looking sense so will view the inflation data as a reaction to their policy. That is, in their eyes, they extrapolated forward the 8%+ inflation rate, took rapid action and this has curbed prices from rising. The Fed will interpret last night’s data as a policy success. In the market’s eyes, however, this ‘policy success’ is entirely spurious since 8%+ inflation rate had been entirely discounted as a possibility.
The danger is that the Fed becomes too bold in fine tuning monetary policy. If the relation between policy and inflation control is indeed spurious, the perceived cause and effect on inflation of aggressive tightening will be a source of uncertaintly for markets in the future, as the Fed adopts a very active agenda, which in turn leads to higher risk premia. The Monetarist luminaries of Friedman, Phelps, Cagan and Brunner (to name a few) from my undergraduate days could at best predict the effect of monetary policy on inflation at a variable lag of 9 to 18 months. The Fed is likely to claim success in just on 6 months suggesting that the inflation bear had not, in fact, escaped. Which is worse: a timid Fed that doesn’t know what its doing or an aggressive Fed that thinks it knows what its doing but does not? I know which one I prefer.
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