The month of May has been rather dull in financial markets. Yes, the media have had a field day as President Trump and his team come under increasing scrutiny and suspicion over their ties and communications with Russia. On top of that, the fallout continues following the sacking of former FBI Director James Comey. On that particular front, the Senate hearing didn’t yield sufficient evidence of a “smoking gun” for the lawyers to argue credibly that the case is proven. Trump stated out loud that he would love it if his former adviser could be “let go”. I’m sure two lawyers could spend the rest of eternity in a courtroom arguing that this did or did not amount to an instruction by Trump (which would constitute a potential obstruction of justice). By the end of that process the American people would be none the wiser… and a lot poorer. So as things stand, nothing to see here. But the investigations continue - and so will the headlines.
With Trump becoming more deeply embroiled in the pre-impeachment process - and the House and Senate and Republicans and Democrats all still singing from completely different hymn sheets - the “Trump trade” has been declared dead (by bond markets at least).
Treasuries continued to rally, flattening the curve and weakening the dollar. Equities are showing their disappointment through sector rotation as opposed to outright weakness. So the declining prospect of Trump-flation is hurting financials, industrials and other pro-cyclical sectors, while defensives and bond proxies have made gains. It’s all rather dull and predictable.
In Europe the economic data continues to show marked improvement and progress towards something that we could class as healthy across the region as a whole. There are still bright spots and laggards. But with respect to the policy normalisation process – the European Central Bank continues to drag its feet like a moody teenager on the way to the dentist. I expect the ECB to wait so long to normalise - under the guise of ensuring they are “certain” about a myriad of economic factors - that they do so into an economy on the turn.
There is a lot going on. Some is good, some is bad. But markets largely ignore all of it. Certainly they ignore it when it doesn’t fit with their pre-dispositions or ideological leanings. This state of affairs will end, and likely in tears, but not yet.
We have all been conditioned (by economists and central bankers) not only to care about inflation, but to care deeply about every little uptick and downturn. We have raised inflation to the status of economic edifice. We have built the entire system around it. Not only is this unwise – it is thoroughly unjustifiable.
Here are some reasons why I believe this.
In the last few months we have seen the Fed’s chosen measure of inflation fall. The headline measure has fallen from 2.2% to 1.7% year-on-year (yoy). The core measure, which strips out the direct impact of changes in food and energy prices, has fallen from 1.8% to 1.5% yoy. This decline has affected bond yields (lower), the curve (flatter), and breakeven inflation rates (narrower). This fall is believed by some, including among some Federal Open Market Committee members, to be sufficient reason to stop, slow or pause the hiking cycle. The notion being that as the Fed has a 2% inflation target then inflation below 2% means no hike. The Fed may agree. We don’t yet know. But in my opinion this thinking is inconsistent and ultimately damaging.
Lower inflation is not always bad – it depends what is driving it.
It is impossible to measure inflation properly (the fact that my new TV costs the same as my old TV but has new and better features may be “disinflation” as far as a statistician is concerned but to the average Joe in the street it still doesn’t mean a cheaper TV).
The theoretical basis for inflation targeting is flawed. Inflation in the literature is defined as a general rise in the level of prices. CPI is not that – it measures relative price moves and aggregates them based on some statistics and a guesstimate of how relevant they are to the average consumer.
The prices of most items in the consumer price index are to a greater or lesser degree driven by factors completely outside the control of any central bank (such as global commodity prices and movements in the foreign exchange rate as well as economic conditions in near neighbours and trading partners).
There has been a complete breakdown in the supposed relationship between unemployment and inflation which is the bedrock of inflation targeting.
Central banks’ reactions to short term gyrations in CPI or personal consumption expenditure (PCE) can be viewed by some as at best naïve.
In the case of both the Fed and the ECB the existence of a 2% target is unnecessary, unjustifiable and not legally binding. Both central banks have in the last few years included these 2% targets as “interpretations” of their legal mandates. In fact both central banks are merely required to deliver stable prices (plus in the case of the Fed “full employment” as it has a dual mandate). The choice of 2% is, by economists' own admissions, arbitrary. It could easily be 3% or even 4%. It could also be 1%, although this would increase greatly the chances of running into the zero lower bound frequently. My point is that shooting for 2% when inflation is already 1.5% - 2% is a choice, not a necessity. And when you have the easiest stance of policy in the history of central banks while real growth is roughly 2% and inflation is 1-2% on top of that, this must surely raise questions.
Historically that approach makes no sense either. We are constantly told that inflation is abnormally low and that’s why we must have all this monetary support. Does that bear scrutiny? It does not. The three-month and six-month averages for headline PCE in the US are 1.9% and 1.75%. The two-year, five-year, 10-year and 15-year averages are: 0.99%, 1.19%, 1.56% 1.80% respectively. I feel these numbers do quite enough talking on their own.
My second observation is that central banks are inconsistent in the application of their mandates. And it is always in the same direction – towards easier policy. In 2011 the ECB was faced with higher inflation during what amounted to an economic and market crisis. Its mandate is inflation so it hiked rates. In retrospect, a damaging decision. What it should have done was look at a broader collection of economic variables to get a more complete picture of the health of the economy, and set policy accordingly. Inflation is a long lagging indicator and the economic weakness would surely have eventually moderated price and wage rises. Which it did. That’s what the Bank of England did in 2010 and is doing now - even when faced with considerably above-target inflation.
The Fed has the opposite problem, but might still be able to come out with a dovish conclusion. Looking at the broad suite of economic indicators in the US, one could only conclude that the economy is healthy and growing and well past the need for emergency levels of monetary accommodation. However, inflation is a touch below target. Is this not the flip side of the ECB dilemma? In my opinion, the right thing to do is to look at the big picture, the broader subset of economic indicators and assume that inflation will follow in its own time. The current ECB might also be falling for this inconsistency as it now ignores all the booming economic data to keep maintain its policy stance because core inflation is still only at 1%.
This is especially relevant when you consider that monetary policy operates with lags of up to two years. A policy change today does not affect the inflation indices tomorrow - it maybe starts to work on them 12 months hence. Micro-managing policy and communication on the month-by-month variability of something we understand so poorly seems inappropriate.
That’s a hugely abbreviated version of my disappointment and concern at the workings of central banks in the modern world (and why I disagree with the thought process which says “we don’t need to hike unless inflation is above 2% and rising”). But to give the Fed its due – I am perhaps being a little presumptuous. It hasn’t yet engaged in the about-face I have hinted at above and it very well may not. But there are multiple market participants who not only think that it will, and also think that it should. So, trying to manage portfolios when faced with such unclear thinking from policymakers and market participants alike has become an increasingly frustrating experience.
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