Tag Archive for: Fed policy

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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Inflation IDK – better raise rates!

I have argued repeatedly in this blog that one of the great economic unknowns is what causes inflation and why.  The classical argument is money supply expansion, which seems to work empirically for hyperinflations, but not for moderate or galloping inflation rates.  Indeed, the best general equilibrium economic models we have are completely devoid of money and the methods that we employ to get money into the system (cash-in-advance [CIA} constraints, for instance) beg justification, particularly in a world where no-one carries ‘cash’ anymore. [A few years ago I asked a brilliant Stanford professor how he justifies the CIA in his policy papers and he just looked at me as if I was thinking too hard. Just the fact that the mechanism got money into the model was enough for him.  I don’t know (IDK)…]

More broadly, the Federal Reserve has just hiked rates by another 0.75% bringing the short-term rate to its highest level since 2008.   This is quite amazing since (i) the jury is still out as to whether inflation is a ‘thing’ now (ii) the Fed doesn’t have any idea what is causing this ‘thing’ and (iii) standard monetary aggregates are indicating no recent surge in the money supply nor the demand for money.  Two things can raise prices – higher demand or lower supply.  One thing can finance inflation – an accelerated money supply growth rate.  It would seem that supply shortages are pressing prices higher – energy, food and shelter, pandemic residuals and labour constraints.  It does not seem that money growth is accommodating/financing price rises across the board.  How does an interest rate hike solve these micro-economic issues?  The stated objective is to reduce demand so as to reduce price pressure but this is a very one-sided view of the world.   Why not lower interest rates to increase supply-side investment and output since this seems to be the cause of the price-spike?  I don’t believe this would work either but it is just as logical as the Fed’s demand-side justification.

The Fed seems to have fallen into the trap of thinking that doing something is preferred to doing nothing, no matter how little they know and how little it addresses the problem.  The world has spent the last 4 decades blissfully free of activist monetary policy.  The Central banks don’t know what to do so they are raising interest rates.


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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.