đź’µ The Target Is Transitory

February 09, 2023 • Estimated Reading Time: 8 minutes

Messaging from central bankers is getting even messier than usual. Are they cracking? Realising that the true costs of bringing inflation down to 2% are simply too high?

Or to borrow a phrase... Unattainable without unacceptable costs đź‘‡

Maybe Powell is behaving this way bc he realizes that the battle has already been lost. Repeat of 1970s, “non-stationary” inflationary spiral, is no longer structurally a serious risk. But a return to the previous decade, stable and average 2% core inflation, is also unattainable… https://t.co/deFxtQN9ak— Steve Hou (“CONSUME LESS!”) (@stevehouf) February 9, 2023 

See, there's been plenty made of Powell's relaxed demeanour in the post FOMC press conference and subsequent chat with David Rubenstein at The Economic Club of Washington 👇

Some suggested that he's confident that inflation's rolling over, and one 'hot' jobs report (filled with seasonal and method adjustments) shouldn't be enough to sway him from the outlook.

However, Steve Hou's argument that he's confidently chopped the extreme tails of outcomes is persuasive.

A return to the '70s is unlikely with demand falling, credit dynamics weakening, and, despite the latest jobs report, a 'not so strong' employment trend ahead as companies shift their focus towards cost-cutting.

Does that mean we simply return to 2% inflation? The so-called immaculate disinflation? It's not an argument I find especially plausible.

Keeping things really simple, I see it as more of an inverse bullwhip effect, where inflation lessens over time, but in a volatile, non-linear way. You won't find this in the textbooks - it's all my own work 👇

(maybe for good reason, but as a simple visual, it works)

Back to those unacceptable costs... And another central banker 👇

Silvana Tenreyro. External Member of the Bank of England's Monetary Policy Committee since July 2017. Dissenter at the last two central bank meetings, and voted (together with Swati Dhingra) to keep rates on hold even as the majority of her colleagues voted through two consecutive 50bps rate hikes.

Her comments today at the treasury committee stood out from the pack. Mainly because she's already thinking about rate cuts!

"Unless there is another big development that we don't know about - and we have a massive energy shock or something that is not on the cards - then I think they fall in inflation is pretty much guaranteed."

The theme of the meeting was to scold the BoE like a group of naughty children for not keeping inflation under control. In that context, calling for rate cuts with inflation still above 9% was incredibly errrm... bold.

But it's also indicative of the new balance. Inflation is falling from the peak, rate hike cycles are slowing/ending, and now we get to see the costs of those decisions...

Which makes each rate hike incrementally harder to sell as a good idea, and in theory, brings rate cuts incrementally closer (as long as inflation isn't trending higher again).

Now, will this result in a formal change to the 2% inflation target?

I think that's unlikely. But it might mean the Fed is more tolerant of slightly above target inflation (or bows to political pressure not to 'ruin the economy with mass unemployment').

More than 30 years ago, some relatively youthful central bank and Treasury economists in New Zealand were grappling with how to bring two decades of double-digit inflation under control in an economy less than 1% the size of its U.S. counterpart.

What if, they asked, they just told everyone the rate should be much lower - say roughly 2% - and then aim for that?

"It was a bit of a shock to everyone, I think," said Roger Douglas, the Labour Party finance minister at the time who worked with the Treasury and Reserve Bank of New Zealand (RBNZ) to pioneer the policy. "I just announced it was gonna be 2%, and it sort of stuck."

Markets are busily pricing rate cuts out of the market again, and even betting on a higher terminal rate since the jobs report.

SQ 

Once the jobs market turns, everything changes. The calls for rate cuts (from markets and politicians) will get louder. The Fed may oblige way before inflation is back at target.

Does that mean stagflation? 

A lot will depend on government spending. The US is going big with the Inflation Reduction Act and CHIPS bill, pushing that fiscal spend through.

EU leaders are debating today and tomorrow whether they should join the US in their quest. No decision is expected until June according to an EU diplomat (the year wasn't specified). This 'industry source' has some strong opinions that we can definitely get on board with:

“If production is so much more expensive in Europe, why would any company invest in Europe?” the source wondered, adding that the current design of the EU ETS will not lead to industrial decarbonisation but instead “further deindustrialisation”.

“This point is crucial because if we do not produce steel or aluminium in Europe, then we will not be able to produce RES units, electric vehicles or other clean tech either. It will simply be easier and cheaper to produce these technologies elsewhere (most likely China or even the USA) where they have competitive access to raw materials,” the source said.

Luckily, they're on the ball and only focused on highly consequential matters...

Negotiations on the RED-3 directive with the EU Parliament were postponed this week because the European Commission has still to agree a definition of "renewable" hydrogen.

Although monetary policy has dominated for the past decade or so, the fiscal channels could become far more important in coming years. Especially if further trade restrictions on China are forthcoming (which seems likely) 👇

 đź‡şđź‡¸đź‡¨đź‡ł U.S. Aims to Curtail Investment in Advanced Military Technology in China

"White House weighing yet another effort to restrict Beijing’s access to advanced tech that could be used in war"

"preparing curbs on investments U.S firms can make in China"https://t.co/B49xisunxp— Tim (@VolaTim) February 9, 2023 

Maybe that's why Powell's so relaxed. He's done his bit and the rest is out of his hands... 👇

We are witnessing an epochal change not seen in decades. The Fed isn’t God. They cannot resist wheel of history. Their effort, even if pivotal, is ultimately second order and marginal. What’s bound to happen is bound to happen. They can put a floor under the tail risks. The rest is really up to history. There’s deep humility in accepting that.

~Steve Hou