The new Federal Reserve isn’t as tough on inflation as it looks

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New Federal Reserve chief Jerome Powell has given the impression that he’s not keen to mollycoddle markets.

After decades of pampering by the likes of Alan Greenspan and Janet Yellen, it’s time for investors to harden up. No more guarantees of an endless supply of cheap money.

But the Fed’s latest minutes suggest that he might be having a change of heart…

The Federal Reserve tips a nod and a wink to the market  

Federal Reserve meeting minutes are pored over by the market. Fed members know by now that every tiny change in vocabulary will be taken as a hint as to what interest rates are set to do in the future.

So they watch their words carefully. If they change a word, or insert a clause, you know they’ve done it deliberately.

It’s a fascinating demonstration of what George Soros would describe as market “reflexivity”. The Fed has learned – painfully sometimes – that its words can move markets.

Early in his tenure as Fed governor, Alan Greenspan said: “If I seem unduly clear to you, you must have misunderstood what I said”. However, the idea that central banks should keep markets on their toes proved to be essentially incompatible with the idea that stock markets should also never fall too far.

The 2008 financial crisis was the final nail in the coffin. In order to get out of the crisis, financial market investors had to be convinced that central banks could solve everything. They had to be persuaded to believe that there was a rock-solid floor in place beneath the market, and that central banks would do everything in their power to keep it there.

So the idea that markets should be kept guessing was replaced with the idea that markets should have absolute clarity on central bank policy at all times, so as not to cause panic. “Forward guidance” became the watchword. This also has the side effect of thoroughly entrenching moral hazard.

Anyway, all of this means that the Fed now chooses and manages its words very carefully. And as a result, markets have learned in turn to take the Fed’s words as a roadmap, rather than the fallible natterings of a small group of human beings in a room.

It’s a feedback loop. The behaviour of one reinforces and changes the behaviour of the other. So the Fed watches the market and the market watches the Fed. The Fed feels more and more like it can gently tap the accelerator or the brake, and the market will listen.  The S&P 500 turns into a speedometer for the economy, in a way.

Which is of course, thoroughly deluded. The economy isn’t like a car engine. It’s more like a weather system. You can’t control it by tweaking one variable, and if you try to, then you just end up building up imbalances elsewhere, which will eventually erupt and give you a serious headache.

But that’s where we are right now. In effect, the Fed doesn’t just lower and raise interest rates now. It also tips a nod and a wink to the market as to whether it should be expecting more or fewer rate hikes. So if it thinks the market is too worried about rising rates, they talk expectations down, and (very occasionally) vice versa.

The Powell Fed starts to go easy on inflation

So in this particular set of minutes, the paragraph that stood out to everyone was this one:

“A few participants commented that recent news on inflation, against a background of continued prospects for a solid pace of economic growth, supported the view that inflation on a 12-month basis would likely move slightly above the Committee’s 2 percent objective for a time. It was also noted that a temporary period of inflation modestly above 2 percent would be consistent with the Committee’s symmetric inflation objective and could be helpful in anchoring longer-run inflation expectations at a level consistent with that objective.”

What does that lot mean, in readable English?

The Fed is meant to keep inflation at around 2%. The Fed now admits that inflation will probably rise above 2%, given that US growth is pretty solid.

However, inflation has been well below 2% for a long period of time. So the Fed reckons that this means it should also allow inflation to run above 2% for a little while.

After all, this is a “symmetric” target, not a “ceiling”. If the Fed put up with the target being lower than 2%, it should also be willing to put up with it being higher than 2%.

In the long run, overshooting a bit might even be a good idea, because otherwise people might start to believe that inflation will always be lower than 2%. (This is what the Fed means when it talks about “longer-run inflation expectations”). These expectations are thought to matter, because if you think prices won’t move much, then you have less impetus to spend and invest today (at least, that’s the theory).

That all sounds very sensible. Where I struggle with the “symmetric” idea is that the Fed has been moving heaven and earth – practically nationalising the banking system – to avoid the tiniest bit of deflation, whereas I can’t see it getting quite as aggressive in tackling a similarly symmetrical bout of inflation.

But the point is – the Jerome Powell Fed has been seen as a swaggering, scary, “take away the punch bowl” Fed. Yet this represents a small move away from that image.

If the Fed is happy to let inflation go up to 3%, say, then that suggests that real interest rates in the US (interest rates adjusted for inflation), won’t be positive for some time to come. So even if rates are being raised, then “real” monetary policy might not get any tighter.

And if that’s the case, then it should also take a bit of wind out of the sails of the US dollar. That in turn, should be good news (for now) for asset prices, particularly in emerging markets.

This move alone may not convince markets that the Powell Fed will embrace inflation. But it does suggest that the new Fed is not that different to the old Fed – financial markets can still rely on the Greenspan put.