Will Averaging Sow Inflation?

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Douglas Adams


  • The Fed's control of inflation expectations appears tentative at best as inflation targeting continues to fall short of its 2% target.
  • A pandemic-induced partial shutdown, millions of jobs lost, the Depression-like plunge in GDP and an anemic national response to a  once-in-a-lifetime pandemic further heightened concern.
  • The Fed's response to the pandemic exigency has clearly benefited those able to monetize US assets in an uber-low interest rate environment.
  • With fiscal help a tenuous bet at best, inflation averaging could tilt a highly skewed balance between capital and labor toward more of a crude equilibrium.

The last sustained stretch of market-based inflation expectations rising above the Fed's 2% target ran from January to November 2018. By July of that year, US unemployment had reached 3.8%, well below the natural non-accelerating rate of unemployment (NARU), typically pegged at 5% to 6%. The national unemployment rate would fall further by November's close to 3.7%. Meanwhile, inflation expectations had peaked in the first week of October of that year at 2.16%, heading down to 1.65% as the S&P 500 peaked in the closing days of February. With the market crash and resulting trough the US benchmark scratched out by the 23rd of March, market-based inflation expectations would fall to 0.50%, the lowest post since December 2008.

The national unemployment rate is, again, in single digits with the recent August jobs report. Similarly, markets are, understandably, questioning the Fed's ability to raise inflation to target. Accordingly, the Federal Open Markets Committee (OTCPK:FOMC) concerned over the body's possible loss of control over inflation expectations moving forward appears well-placed. Since its inauguration in 2012, the Fed's record on creating inflation remains spotty at best. The records of both the Bank of Japan and the European Central Bank since the millennium, are, arguably, even more problematic on the subject.

In response, Federal Reserve Chair, Jerome Powell, recently announced a new tilt on gaining control of inflation expectations in last month's first-ever, live (virtual) meeting of central bankers from around the world. What this means is the Fed is not going to pre-emptively tighten monetary policy to prevent the US economy from overheating as the national unemployment rate falls. While the Phillips Curve is far from being swept into the dustbin of history, the correlation of inflation with falling national unemployment remains suspect.

The change is potentially singular, if for no other reason than the resulting dollar exchange rate, as the world's leading currencies will largely determine the pace of the post-pandemic recovery. About 88% of daily transborder currency trades still happen in dollars. Since June, the dollar (green-red line) has suffered a closely watched reversal of fortunes. The pandemic-induced market slide created a global stampede for US assets despite US Covid-19 death and infection rates topping global charts. While US assets continued to provide safe haven to investors worldwide, an administration that routinely questioned the breadth, scope and impact of the unfolding pandemic at almost every turn added little in the way of comfort or assurance. Emerging market currencies have seen their values against the dollar plummet. The Brazilian real is down 32% on the year while the Mexican peso is down 16% against the dollar over the same period. The Russian rouble is down about 22%.

Meanwhile, the renminbi is at its strongest level in more than a year against the dollar at Rmb6.83, up over 5% since March. China's exports volume jumped 9.5% in August in dollar terms YOY. Yet for most EM countries, rather than being a driving force for EM exports, dollar-priced EM commodities have proved to be less-than-effective shock absorbers as EM currencies weaken. EM economies suffer disproportionately as global growth moves to the downside.

The dollar spiked to a three-year high with the market crash as the greenback suddenly became scarce in many global markets. The Fed stepped aggressively into the market turmoil, backstopping both traditional and novel markets while hastily arranging dollar swaps with central banks in both advanced and emerging market countries. The Fed's balance sheet has grown to $7.1 trillion through the 2nd of September, up from $4.3 trillion on the 5th of March. At the same time, the broad measure of US money supply or M2 has soared to $18.4 trillion through eight months, up from $15.3 trillion at the start of the year with the joint monetary/fiscal response to Covid-19 through the end of July. While the pandemic's impact on the greater economy makes deflation the more logical bet, the outsized nature of the increase in M2 is hard to miss.

With the fall of interest rates in the US to near zero and as both monetary and fiscal stimulus began to be absorbed by the US economy, the dollar's appeal began to recede, largely erasing the relative US growth advantage with European and many Asian economies in its wake. The Fed's inflation averaging announcement has, initially at least, furthered the dollar's slide. The euro (pink line) has surged in the wake of the dollar's slide as investors appear to have gained more confidence in a eurozone recovery with the ECB's recent announcement of a €750 billion recovery fund. For the ECB, the rise of the euro is more problematic for growth as a rising euro makes the region's export economies less competitive in global markets. The rising euro all but guarantees a further cut in the ECB's forecast for inflation at this week's governing council meeting. Following the dovish lead of the Federal Reserve on inflation averaging will likely be a primary topic of discussion. Already at minus 0.5% for its main lending rate, the ECB has precious little room for maneuver on interest rates.

A similar picture emerges in Japan with the appreciation of the yen (purple line). While nuanced by the ever-changing temperature of Brexit, British sterling (orange line) has managed an uptick against the dollar since June. More recently, the pound has lost traction against the dollar after a report that the UK was considering legislation that would override key parts of the divorce agreement already inked with Brussels. Derivative contracts that pay out if the pound becomes more volatile surged yesterday with three-month contracts hitting their highest posts since May. At the same time, the pound has slipped 0.8% against the euro as upcoming Brexit talks this week will likely be as heated as their outcome challenges predictability. Meanwhile, gold (grey area), largely quiescent and trading in a narrow range since peaking in August 2011, unsurprisingly scratched out a new high the first week in August as the dollar slipped to the downside (see Figure 1, below).

Figure 1: The US Dollar, British Sterling, Japanese Yen and Euro against Gold Continuous Contracts

With further fiscal response apparently mired in the throes of the upcoming US election, the Fed and monetary policy appear poised to go it alone. The reality continues to give investors pause. While low borrowing is a boon to mortgage refinancing, new home construction, corporate debt issues - not to mention stock markets - the Fed's ability to influence household spending in the greater economy remains limited. Consumer spending fell 12.9% in April MOM before rising 8.6% in May and another 6.2% in June. By the end of July, consumer spending was up just 1.9% over June's total as fiscal stimulus payouts drew to a close. Long-term Treasury yields rose sharply on the Fed's announcement - only to fade soon thereafter as the selloff failed to gain traction. Relative growth, rather than an upward bump in interest rates, is likely to be the driving mechanism for the dollar moving forward. The continuing appearance and reappearance of Covid-19 hotspots across the country still serve as a poignant reminder of the Trump administration's helter-skelter approach to pandemic containment that has now claimed almost 190,000 US lives. The breakdown of fiscal stimulus talks between the White House and Congress, Democrats and Republicans create further headwinds for the dollar in world currency markets. With August's job creation still falling short by some 11 million jobs from February pre-pandemic totals and the month's wage growth rising rather than falling MOM, working families still in need of fiscal stimulus help to pay for food and shelter costs find themselves scrambling to make financial ends meet. Unsurprisingly, consumer confidence took a hit in August, falling to a six-year low.

Out of the box, averaging inflation will likely mean a decline in transparency given the lack of mention as to how the measure will be averaged and over what time frame. The parameters of inflation bands to the upside and the downside have yet to be determined. This lack of transparency appears curious given the effort the Fed has expended toward messaging during the Powell tenure. Averaging inflation over a yet-to-be-determined period of time may also trip up the Fed's transmission mechanisms to the greater economy as lead and lag times between tight labor markets and wage growth create added uncertainty for markets as they strive to interpret the Fed's messaging around inflation averaging. These added challenges are real. Still, averaging inflation appears sensible and should make for more flexible policy decisions. Arguably, such flexibility appears lacking in current economic modeling that struggles in the wake of a once-in-a-lifetime pandemic event. The Fed has again tilted the scales toward capital as US bourses continue to post record market closes. With fiscal stimulus hopelessly mired in election-year politics, by tolerating more variance in prices for the greater economy, inflation averaging has the potential to move a highly skewed balance between capital and labor toward more of a crude balance.

This article was written by

Douglas Adams profile picture
Douglas Adams specializes in macro-economic research and turning theory into practical portfolio applications for clients over the past seventeen years. Mr. Adams recently formed Charybdis Investments International based in High Falls, New York where he is the managing director of a fee-only investment advisory practice with clients throughout the United States. As an author, Mr. Adams has commented widely on a diverse array of topics from Brexit to monetary policy to forex to labor productivity and wage growth. He holds an undergraduate degree from the University of California, a master’s degree from the University of Washington and an MBA in finance from Syracuse University.

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.

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