Do As the Fed Does

Macro Perspectives: Mon 25 Oct 21

In my last note we talked about the sentiment among the big influential investors about the path for interest rates - most are seeing hot inflation persisting, but most are not seeing a response of dramatically higher interest rates.

That suggests that the Fed will remain passive on inflation, and ultimately let higher prices solve higher prices.

Following on, in prepared remarks, the Fed Chair, Jerome Powell, may have set expectations for this scenario on Friday morning (NY Eastern time). After telling us all year that inflation would be short-lived, he admitted that supply chain constraints have gotten worse, and that higher prices from the supply chain disruption will last longer than they expected. He said that the Fed's "tools don't do much for supply constraints."

So, the political talking point has tied higher prices to the supply chain and Powell seems now to be using that as cover.

That said, it's clear to everyone paying attention that inflation is being driven by factors other than bottlenecks at the ports; wages, shelter costs, transportation costs, food, energy. Many of these are sticky. When they go up, they don't come back down. This includes energy, in the current case. An agenda-forced underinvestment in fossil fuels, has created a structural supply shortage and there's also this issue: a 30% growth in money supply over the past eighteen months (inflationary).

As we've discussed in the past, this Fed response, which seems disconnected from reality, is all part of their "guidance" strategy.

"Guidance" is code of perception manipulation. What the Fed fears more than inflation itself, is consumer (and business) inflation expectations. If you expect higher prices, you might behave in ways that lead to higher prices (and potentially runaway prices). If the Fed can convince you that prices are stable, you may behave more normally in your consumption. Moreover, if they can convince investors of the same, they can manufacture stable markets.

As an example, back in July, after the Fed repeated this idea for months that inflation was "transitory," a survey of fund managers showed that 70% thought inflation was temporary. The Fed's messaging worked and, as such, three big inflation indicators in the markets were behaving in a way that confirmed the fund manager viewpoint: stocks were trading to new record highs, the 10-year yield was stagnant around 1.3% and gold was 13% off of the all-time highs.

Here we are three months later, and the inflation picture is clearly hotter - and not abating anytime soon - with  the Fed having changed its tune. But its strategy seems to be working, still. Stocks are on record highs, the 10-year is at just 1.6%, and gold remains 13% off of record highs.

All of this said, as we've discussed over the past year, we should pay attention to what they do, not what they say. With that, they will begin reversing emerging monetary policies next month.