In each episode of the documentary “The Last Dance,” Michael Jordan has a bad game and feels slighted by the other team. Then he comes back and wins. 1 1 Close https://www.youtube.com/watch?v=Ss5Ndz0tn9o The opposing team learned that if Jordan took something personally, he would make them pay. In economic terms, this pattern of behavior is known as a “reaction function.” For a central bank, its reaction function is how it responds to economic conditions. Maintaining a clear reaction function is an important part of monetary policy. It gives the central bank the ability to affect economic outcomes without having to make aggressive policy moves. Imagine a perfectly rational world where everyone has access to all information. 2 2 Close I agree, it’s hard to imagine. If economic actors know the Fed will raise rates if prices go up, they may not increase their prices. 3 3 Close It’s like if a team knew that Steve Kerr could make the shot, it wouldn’t triple-team Jordan. The simple expectation can help the Fed achieve price stability.
Since the early ‘90s, the Fed has kept a consistent reaction function during economic recoveries: it hikes rates preemptively to combat future inflation. Alan Greenspan laid this strategy out in his testimony to Congress during Jordan’s first retirement in January of 1994, “By the time inflation pressures are evident, many imbalances that are costly to rectify have already developed … the challenge of monetary policy is to detect such latent instabilities in time to contain them.” 4 4 Close Hearing Before the Joint Economic Committee, January 31, 1994. This theory is based on two concepts. First, monetary policy acts with a lag. Fed rate hikes may not affect the economy for three to six months. Second, inflation can feed on itself. Once inflation starts to rise, it continues on that path. According to Greenspan, if the Fed kept rates low for too long, it would later have to take drastic action and raise rates to exorbitant levels just like it did in the1980s.
To put this in basketball terms, Greenspan wasn’t waiting for LaBradford Smith to score 36 points before coming back the next day and torching his opponent. 5 5 Close Sadly, that was probably the highlight of LaBradford’s NBA career. He didn’t even have the career his teammate “Never Nervous” Pervis Ellison had. In the year following that testimony, Greenspan hiked rates by 3% in clips of 25, 50 and 75bps. The economy slowed but avoided recession. Greenspan felt like he had done the monetary policy equivalent of beating the Lakers in an NBA finals – he engineered a soft landing for the economy. Although he did not repeat this success with the next hiking cycle in 2000, or with the one he began in 2004, his preemptive action on inflation served as a template. After Greenspan retired, his successors have also hiked preemptively. 6 6 Close The rate hikes became slower and slower during each cycle. There hasn’t been a 50bp hike since 2000.
These moves were part of the larger Fed reaction function across the business cycle. The Fed hikes until the economy slows down. It pauses, then cuts rates to prevent or alleviate the effects of a recession. While the Fed’s strategy has remained mostly the same, the economy has changed. Rates have gotten progressively lower at the troughs of each cycle. In 1994 rates were at 3%, then in 2004, 1%, and all the way to zero in the two most recent cycles. Inflation does not seem to be the menace it once was. It is only natural that current Fed Chair Powell is looking for a new approach.
Powell first broke recent tradition by halting rate hikes early, but that did not deliver a soft landing. Now that rates are back to zero, he and his colleagues will have to consider whether to act preemptively on inflation. Forecasts are for inflation to stay low for quite a while, so they have some time to think about it. Fed members such as Vice Chair Clarida and New York Fed President Williams have discussed the virtues of letting the economy run hot before hiking. 7 7 Close “The Federal Reserve’s Review of Its Monetary Policy Strategy, Tools, and Communication Practices,” Richard Clarida at “A Hot Economy: Sustainability and Trade-Offs” event sponsored by the San Francisco Fed, 9/26/2019. “Discussion of ‘Prospects for Inflation in a High Pressure Economy: Is the Phillips Curve Dead or Is It Just Hibernating?’ by Peter Hooper, Frederic S. Mishkin, and Amir Sufi”, John Williams, 2/22/2019. Lael Brainard gave a speech providing academic backing for a revamped reaction function on July 14th when she said “Research suggests that refraining from liftoff until inflation reaches 2% could … help offset the previous underperformance.” 8 8 Close “Navigating Monetary Policy through the Fog of COVID,” Lael Brainard, 7/14/2020. That research she cites was co-written by former Fed Chairman Bernanke. 9 9 Close “Monetary Policy Strategies for a Low-Rate Environment,” Ben Bernanke, 2019.
The Brainard speech was picked up as the basis for a WSJ article, which shows that the view is gaining traction. 10 10 Close “Fed Weighs Abandoning Pre-Emptive Rate Moves to Curb Inflation,” WSJ, 8/2/2020. Not coincidentally the Fed is conducting a so-called “comprehensive review” of its policy. If the Fed does follow the research Brainard cites, it implies holding rates low for considerably longer than in the past. To put this in perspective, during the most recent cycle the Fed hiked for the first time in 2015. Its favorite measure of inflation, core PCE, was well below 2% at the time. In fact, it didn't get back above 2% until 2018. 11 11 Close Core PCE briefly got above 2% in 2012 when the Fed was looking at easing rather than hiking. That’s a long time to wait.
The Fed does not have a formal announcement in which it spells out its reaction function. 12 12 Close Though many folks think they should. John Taylor for example thinks it should be rules-based. Fed watchers piece it together by looking at what the members say and what the committee does at the meetings. Unlike QE or Yield Curve Control, a change to the reaction function is not exactly a policy move, but it may be more meaningful. It has implications not just for the current year, but also for multiple cycles going forward. To the extent that the Fed is credible in its communication, this should increase longer-term inflation expectations. The Fed may become more explicit about its intentions in future meetings, perhaps as early as September.
Perhaps the strongest evidence of the shift has been in what the Fed hasn’t said. Fed members have not meaningfully pushed back against higher equity prices, nor have they expressed any real concern about higher gold prices or the weaker dollar. This is part of why inflation assets such as gold and TIPS have done so well recently. In the past, a Fed Chair may have worried about irrational exuberance and taken any rise in inflation personally. That Fed Chair may also have watched the Bulls beat the Pacers and the Jazz. That’s not something we’re likely to see today.
Probably because the Bulls didn’t make the bubble.
What We Are Watching
U.S. Fiscal Policy
Negotiations between Republican and Democrat policymakers in the U.S. on the new round of fiscal relief for the pandemic have extended beyond the July 31st deadline for some key provisions to expire. In particular, the enhanced unemployment insurance benefit of $600/month ended on July 31st. Despite some reported progress in the discussions, meaningful differences appear to remain between both camps, which could presumably lead to continued negotiations during the upcoming week. The main contentious points appear to be the magnitudes of the enhanced unemployment insurance and the support for state and local governments. Differences seem to have also emerged around provisions to protect businesses against COVID-related lawsuits. An agreement on the fiscal package remains a cornerstone of the recovery in the U.S., as a sudden stop of fiscal support could reverse the economic progress observed in the past few months. If politicians can reach a deal this week, it would remove some downside risk to the near-term outlook and support risk sentiment. However, if negotiations extend beyond the self-imposed August 7th deadline uncertainty may weigh on markets. The Senate has officially postponed the August break which was to start on Friday and while the House is on break, representatives have been told that they could be recalled on 24-hour notice to vote.
U.S. CPI (Wednesday)
Core U.S. inflation has softened dramatically this year driven by weak demand in sectors hit hard by the pandemic. Apparel, hotels, and airfares stand out as big deflationary components of U.S. CPI on the year, although they have recently posted positive price growth as the economy re-opened. However, perhaps the most relevant categories in the index to form an expectation of inflation in the months ahead are rents and owners’ equivalent rent. These are slow-moving items that last month came well below their trend inflation rate. Anecdotal evidence points to weakness in rents as people have left cities amid the pandemic either because of loss of jobs or because of the flexibility of remote work. Should this become a trend, core CPI would face substantial headwinds. Market focus on next week’s release will probably be on these items within shelter index.
Reserve Bank of New Zealand (Tuesday)
The RBNZ struck a dovish tone in its June meeting despite flagging “a marginally stronger starting point for the NZ economy” and “improvements in the outlook since the May MPS.” Notable dovish elements were their view of risks as still being skewed to the downside, the mention that staff is working towards a broader set of tools deployable in coming months, as well some concern about the NZD appreciation. However, inflation and labor market data released this week made the upcoming central bank meeting harder to predict. The unemployment rate came in better than expected as did job creation. While the relevant 2-year inflation expectation metric rose close to 0.2% for Q3 relative to the prior reading. With signs that the economic recovery is under way, the RBNZ may be inclined to stay course, acknowledging the improvement in the data but noting downside risks conditional on the trajectory of the COVID-19 pandemic. Market participants will likely focus on the tone of the central bank when taking stock of the most recent information. A relatively neutral or bullish outlook may drive strength in the New Zealand dollar.