The Federal Reserve Chairman, Jerome Powell, said during his grilling before the Senate this week that the relationship between inflation and unemployment is gone. Didn’t he and former Federal Reserve Chairs; Janet Yellen and Ben Bernanke, say to just be patient? The low inflation figures are transitory because low unemployment will drive wages higher? If you mean a decade or longer, then yes, the super low inflation of the last 10 years is transitory. That expectation, by the way, was the reasoning behind the last 10 or so increases in the Federal Funds rate, the short term borrowing rate that’s controlled by the FED. During its FOMC meeting last month, the FED further downgraded its inflation expectations for next year.
Hey, this is no kick against the Federal Reserve. Its purpose and dual mission, to maintain inflation and employment, are critical to our economy. The Fed is also a major regulator of our financial system and money supply. So, FED haters, this is not your rallying cry to call for its demise or strip it of its independence. That doesn’t mean, however, that I’d let my fandom blind me to its deficiencies. Jerome Powell admitted today that their number one tool, the Phillips Curve, no longer works. The curve states that inflation and unemployment are locked in an inverse relationship. So, if unemployment goes down because more people have jobs, wages would have to go up. Basically, it represents the supply and demand ratio of wages. This curve is dogma in the world of economics, so to say it no longer works is pretty huge.
Wall Street strategists, corporate decision makers, and economists have a long standing practice of abandoning ingrained market relationships after they haven’t worked as expected for a long time. But my experience tells me that you never say never. Financial market trends come back into vogue. Human nature remains constant over long stretches, despite how many times people change their minds about things over the short term.
There are lots and lots of reasons given as to why inflation just won’t reach the FEDs target of 2% on its preferred inflation gauge, the PCE (Personal Consumption Expenditures):
Ever since Microsoft was created, the world has been in a technology driven wage deflation force.
Too much capacity in everything man-made and mined.
Too much sovereign (government) debt that is stealing productivity from the private sector.
Globalization has shifted high wages to low wages all around the world.
Shale oil has driven energy prices lower, making everything less expensive.
Take your pick. I know we can come up with more reasons than those, but those are the most popular ones. So far, they all sound perfectly plausible now. But wages finally started going up for the bottom 1/3 of the workforce. This is a very recent phenomena, so it remains to be seen if it has staying power. The point of this missive is that the overwhelming majority of market participants is on one side of the inflation argument. I wouldn’t waste your time with a timing prediction of when inflation could grow and force the FED to tighten policy and keep it that way. But my experience does tell me that betting with the crowd has never produced good results and, in fact, is downright dangerous. Inflation is cyclical, like everything else in markets. The FED’s guard against inflation was lowered because it’s extrapolating current low inflation expectations into the future and markets are loving it. But now that every market participant is on the same side of the inflation trade, even lower inflation may not be good enough to meet investors’ expectations. We're in La La Land now. Proceed cautiously.
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