The Central Bank That Cried Wolf

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by: Adam Whitehead

Summary

James Bullard's change in rhetoric signals a general shift in focus and perspective by the Fed.

The Fed is now promoting a thesis of rising inflation and stronger economic growth.

Behavioural economists have noted that the Fed is facing diminishing returns on its attempts to frame market expectations.

The IMF is supporting the Fed's change in rhetoric by attempting to talk oil prices higher.

Market sentiment has become polarised into two extreme opposites on the path of US economic growth and inflation.

Click to enlargeThe last report discussed the "soul searching" at the Fed in order to move its perspective from the domestic economy to the global economy. This soul searching process has begun to undermine the credibility of certain Fed officials and the institution as a whole. The coincidence of the changes in the Fed's focus, with swings in the global equity markets, is also starting to have a predictability that leads to conclusions that this is the Fed's real focus.

The topic of James Bullard's "soul searching" is turning out to be good value for money. A previous report entitled "Mr Market Shifts the Dot Plots and Their Plotters" observed James Bullard "manfully" leading the crusade to get the Fed to pay more attention to its undershooting of its inflation target. According to him the FOMC was way behind the curve and should adjust its language to become more contemporaneous with the current deflation threat. This last report also noted that Bullard's ardent anti-deflation rhetoric coincided with a compromising uptick in Mr Market's inflation expectations.

Not to be undone by this sudden uptick in inflation expectations, Bullard has swiftly changed his position again. As of his latest guidance, low interest rates actually lead to deflation. Consequently, he now thinks the Fed should engage in a debate about the merits of raising interest rates to hit its inflation target. Having lectured his colleagues about the risks of undershooting the inflation target, he now believes that they will actually overshoot it.

Sadly, Bullard is a voting member this year; so his vacillation just muddies the waters for observers and presumably his colleagues too. To be consistent with his words, Bullard advocated staying on hold at the last FOMC meeting. His vector is therefore moving from on hold towards tightening, for observers who can be bothered to take him at face value. Just to provide a little more velocity, in line with the changing market dynamics on inflation, he then opined that the tightness in the labour market will justify another rate hike. Bullard has therefore deftly moved to reflect the current view being discounted by Mr Market.

Jeffrey Lacker has refused to waver, even in the face of the market sell-off in January which moved his more flexible colleagues. He still sees the US economy on course to sustain an inflation rate that will accommodate more interest rate hikes this year.

Dennis Lockhart is more flexible than Lacker, yet less volatile than Bullard. Having stayed on hold at the last meeting, in view of the global headwinds, he is now confident that the Fed can attempt another rate increase in April.

Charles Evans, a noted Dove who does not vote this year, is also coming to the acceptance that interest rates must go higher. Whilst maintaining a "wait-and-see monetary response", he intimated that he expects to see both increasing growth and inflation rather than the opposite.

Dallas Fed President Robert Kaplan would also like to see the Fed tighten as swiftly as possible back to normal but understands the global hurdles to getting there.

The Fed is playing the dangerous kind of game that behavioural economists understand. Under pressure from a global sell-off in risk assets, the Fed was forced to save global markets with its posturing at the last FOMC meeting. No sooner had the global markets been saved than the Fed immediately went back into the kind of domestic inflation watch mode that is antipathetic towards global markets.

The problem with this equivocal behaviour is that the Fed speaks but does not act. At some point observers are going to tire of being guided in this way, when there is no substance in Fed actions or real supporting evidence in the economic data. Credibility, which is the essence of the Fed's ability to execute policy is being undermined.

If the Fed just admits that it does not understand what is happening, then its credibility is immediately lost. It is therefore obliged to constantly hazard a guess through words. Once these words begin to consistently conflict, at subsequent FOMC meetings, the Fed's credibility will also erode but at a slower rate.

The current drama of the Dot Plots, classically illustrates the Fed's credibility dilemma. The Dot Plots have persistently been way out of line with economic reality. This economic reality has also been closer to that suggested by the discounting mechanism according to Mr Market. This credibility problem was discussed in the report entitled "Mr Market Shifts The Dot Plots And Their Plotters". The corollary effect has been that the Fed is now in search of ways to drop the Dot Plots altogether. James Bullard is on record for saying that: "I've even thought about dropping out unilaterally from the whole exercise".

For Bullard, the Dot Plots now actually contribute to uncertainty. He should be reminded that there is no such uncertainty in Mr Market's mind; and that the FOMC has been forced to adopt his certainty with increasing frequency and embarrassment. Bullard is therefore at risk of appearing like someone who shoots the messenger because he does not agree with the message. The Fed should appear to be bigger than this.

Click to enlarge

(Source: Seeking Alpha)

It has therefore fallen to Stanley Fischer to employ all his powers of casuistry to come up with a credible story for why the Dot Plots are being dropped. How this is handled will by and large determine how successful the Fed is at regaining its credibility, enough to start to frame policy rather than to react to Mr Market.

(Source: GMO)

This fallibility of the Fed has been picked up on in an interesting piece of behavioural finance research by GMO. This research finds that the Fed has been playing with the "animal spirits" of the market just by meeting, rather than through executing monetary policy actions. The Fed is therefore following a mandate that targets the level of asset prices, rather than its dual mandates. In fact, one may infer that these dual mandates are only used as a cover for the real business of asset price inflation.

Click to enlarge

(Source: GMO)

The FOMC's recent behaviour at the last meeting and subsequent swift retraction only serves to underline this observation. The stark conclusion is that the power of the FOMC to drive asset prices higher with this tactic is waning. If equity markets now fail to go back to previous highs and beyond, this thesis will be confirmed in the price discovery process.

(Source: IMFdirect)

It is noteworthy and no coincidence that the IMF is zagging in the same direction as the Fed in relation to what comes next. The IMF has noted that inflation and inflation expectations have been taken hostage by the oil price through a direct correlation that is perceived as a causal relationship.

The IMF now argues that negative interest rates have cancelled out the stimulus effect of falling oil prices by undermining the monetary transmission and credit creation process in the banking system. Oil prices and interest rates should therefore go up to restore economic growth and rising inflation expectations. It all sounds so simple such that one wonders why intelligent central bankers have deviated into negative interest rate territory.

The answer lies in the fact that the oil price has not been targeted by central bankers … presumably until now. Perhaps central banks should have been buying oil and not financial assets. Perhaps they will now start doing this. It is hard to take the IMF seriously at this stage, other than to speculate that it is trying to use the bounce in the oil price to engineer a change in market perceptions that then translates into central bank actions.

What gives the IMF's game away is that it directly links oil prices with the value of equities. Like the Fed, it is therefore in the game of inflating and maintaining asset price bubbles. The IMF's analysis thus highlights the fact that the collapse in oil prices is strongly linked to a fall in equity valuations and hence another Credit Crunch scenario. Currently it is engaged in a game of behavioural economic guidance of its own to accelerate the momentum in the oil price rally in order to push equity markets higher.

The "soul searching" on the FOMC and at the IMF is mirrored by the "soul searching" on Wall Street. There is as yet no unanimous consensus and perceptions have been polarised into two camps.

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(Source: Bloomberg)

Deutsche Bank is indicative of the camp that is calling for an economic slowdown and hence a premature end to the rate hiking cycle. Deutsche sees dwindling tax revenues as indicative of a slowdown. This also has negative implications for the ability of policy makers to respond with a fiscal stimulus. The heavy lifting obligation will then by necessity fall back onto monetary policy and thus the Fed.

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(Source: Bloomberg)

Goldman on the other hand sees the uptick in US inflation requiring four rate hikes this year, despite the weakness in the global economy.

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If only life were so simple, that one could fall into either camp. Evidently both camps are correct, but are mistaken by their belief that both outcomes are mutually exclusive. Mr Market is playing both outcomes off against each other in real time; and hence the FOMC in the process. Observers should therefore understand this discounting process and remain flexible in their beliefs as the narrative unfolds.

Observers should not assume that the Fed will abandon its strategy of tactically manipulating asset prices higher. The Fed will simply look for a new tool to achieve this strategic objective. Since the Fed has currently ruled out negative interest rates, some observers are concluding that it will make the quantum leap past the BOJ and ECB to Helicopter Money. This leap will have to wait for the current theme of rising inflation and interest rates to trigger the sell-off in asset prices which provides the catalyst for the consideration of Helicopter Money.

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(Source: Bloomberg)

For now, the Eurozone is the laboratory for unconventional monetary policy ideas to get tested. Stanley Fischer is on record for opining that negative interest rates seem to be working well, despite all evidence to the contrary. The Eurozone is also the place where Helicopter Money is anticipated to land first; so Fischer's comments about its utility and efficacy there, in the event that it lands, will make for interesting reading.

Disclosure: I/we have no positions in any stocks mentioned, and no plans to initiate any positions within the next 72 hours.

I wrote this article myself, and it expresses my own opinions. I am not receiving compensation for it (other than from Seeking Alpha). I have no business relationship with any company whose stock is mentioned in this article.