Don’t Worry, Jerome. I Got You

The Federal Reserve’s new philosophy towards its inflation targeting policy came as no surprise to investors. Many people expected Powell to introduce lower restrictions on inflation, but they aren’t fully appreciating what this means for long term economic growth.

By Aidan Levi-Minzi

On August 27, the United States Federal Reserve announced at its annual Jackson Hole economic symposium that they would be implementing a new strategy in regards to its average inflation targeting. The central bank has been taming inflation for the past four decades, which seemed to be the right move given that inflation averaged about 7.25% in the 1970s and 5.28% in the 1980s. In 2017, Fed Chairman Jerome Powell informed investors that their new target inflation rate would be around 2%. Since then, inflation has hovered around 1.5%-1.7%, falling just shy of the 2% mark he envisioned. This new strategy will allow the Fed to let inflation run above this 2% mark in order to offset the lower inflation rates of the past few years, meaning that they will not only allow, but welcome inflationary flare ups. 

Whenever chairman Jerome Powell makes an announcement regarding Fed policy changes, investors will dissect his statements down to every minute gesture he makes. Once the statements have concluded, they are usually followed by an influx of market volatility and a major discussion amongst journalists and pundits. However, this particular symposium was met with neither of these reactions. Granted, these statements come during an unprecedented period that has seen a strong divergence between the stock market and the economy, a surreal amount of easing financial conditions, and a market recovery that has played out in an impressive time frame. The symposium’s agenda informed attendants that the main talking points would revolve around a new Federal Reserve framework for measuring and managing inflation, and many investors brushed off his statement as one to be expected. In reality, what was being said is big news, yet it is  being underappreciated by markets. 

Nearly 40 years ago, former Federal Reserve Chairman Paul Volcker introduced an era of inflation management that would shape many of the macroeconomic models we know today, including the Phillips curve, the real cash balances mirage, and Gibson’s paradox (which was technically coined by English economist Alfred Gibson in 1923, but took on a whole new meaning with America’s implementation of fiat money in 1971). The grounds for which these theories are based upon have shifted completely. And markets barely blinked. On September 2nd, a week after the symposium, the S&P 500 had gained 10% over the previous year and was up 200 points since early March, when the US economy first shut down. 

Most American high school students remember two things from history class: don’t invade Russia in the winter, and printing money is a bad way to pay off debt. The idea of inflation originates from the time of Nicolaus Copernicus in the early 16th century, who used his knowledge as a mathematician to explain the increasing price of goods and services in the Kingdom of Prussia. He found that the general price of things has a positive relationship with the money supply, an idea later known as the Quantity Theory of Money. Fast forward four centuries, and American economist Irving Fisher modeled how nominal interest rates can be affected by real interest rates and not just inflation, but expected inflation. If people believe that inflation will increase in the near future, they will put their assets into interest-bearing assets, such as savings accounts or treasury bonds, rather than holding cash. Because they expect the value of their dollar will decrease tomorrow, people will want to spend that dollar today. With more and more people getting rid of their cash, the velocity of money, or the rate at which it is exchanged, increases. According to our Quantity Theory of Money, that increase will lead to a rise in price levels and inflation. This increase in inflation only confirms the individual’s worries of expected inflation, which fuels their next wave of expected inflation, and a vicious cycle has presented itself. The results of this cycle can be seen in 1923 Germany, 1946 Hungary, and modern-day Venezuela.

This graph shows the relationship between interest rates and inflation. There is clear evidence of a positive correlation amongst the two measures. As shown in the early-mid 1970s, when expected inflation has been confirmed, it continues to rise.

This is why the US Federal Reserve has practiced what is known as an open mouth operation. By presenting future policy strategies and giving the public forward guidance on how they expect money growth and inflation to change over the next 12-18 months. This led to their average inflation targeting, which pushed them towards their presently open-ended view of the zero lower bound for the Federal Funds Rate. Along with encouraging inflation, the Fed has adopted a new outlook on the relationship between inflation and unemployment. They will no longer react to price stability signals or fundamental labor market signals, a hallmark trait of their previous policy-making decisions. This, coupled with the fact that inflation expectations are already high due to the massive stimulus packages and quantitative easing measures, will only drive inflation higher. 

The only area of Wall Street that seems to have understood the impact of Jerome Powell’s statements is the Dollar. The Trade-Weighted US Dollar, a measure of the value of the US dollar based on its largest trading partners, has weakened over the past few months, taking a significant dip after the August 27th remarks. As seen in the graph, higher inflation usually accompanies a weak dollar.

In the broader spectrum of the American economy, higher inflation can have a number of implications. Rising prices obviously cause the present purchasing power of individuals to decrease, meaning the dollar in their pocket may be more like 70 cents in a couple of months (this is a hyperbole, unless the Fed plans on tying the US Dollar to the Venezuelan Bolivar anytime soon). However, there are less obvious costs of inflation. People have to more carefully manage their money, like opening another savings account or going to a broker and investing in bonds, which incur a cost on both the individual and the institutions that provide these services. These are known as shoe leather costs, as the shoes you’re walking in will be quite worn after travelling from bank to bank searching for the one with the best rates. Menu costs refer to the other side of the market, where businesses now have to allocate considerable resources to making sure their prices are up to date with the value of the dollar. In 1924, some German bakers began pricing their pastries in US Dollar terms, because by the time they actually wrote down their daily prices on the chalkboard, its price would have changed. 

While this may not seem like a big deal to America in the 21st century, it is important to return to the graph on inflation and remember that it has not surpassed the 2.5% level in the past 10 years. Once that percentage begins to rise, consumers and producers alike will feel the pinch. 

Another area to consider are the effects of higher inflation on financial markets. Financial markets are generally a good indicator as to the health of the economy, even if recent events have shown otherwise (the S&P 500 has reached an all time high despite record unemployment claims thanks to the quantitative easing that has propped it up). Higher inflation has an immediate impact on fixed income securities, such as corporate and treasury bonds. The loss of purchasing power leads to a repricing of medium and long term maturities, which can steepen the yield curve. Looking back to our menu costs, stocks will see a decreasing P/E ratio as companies will find that their operating costs increase with inflation, which will ensure narrowing profit margins. 

In 1949, Benjamin Graham wrote The Intelligent Investor, one of the greatest books on value investing. He devoted his entire second chapter to describing how an investor can hedge himself against inflation. If an investor’s returns are not kept up with inflation, then he is essentially losing money. By keeping a diversified portfolio of both stocks and bonds, an investor can have some level of protection against large-scale inflation. This is no longer the case. Because the Fed has kept interest rates so low, investors cannot depend on bonds as a fixed income tool. Two securities that usually have a negative correlation have suddenly turned positive, and the impact of higher inflation is set to hit them both at the same time. 

This is in no way a slight towards Jerome Powell and the Federal Reserve. Adam Smith’s invisible hand will prevail, as it has since the invention of barter, and new theories will be implemented to accommodate for the change in policy philosophy. It is the lack of response from financial markets that seems puzzling. What Mr. Powell said comes with many strong implications, and the markets need to prepare themselves. □


Work Cited

  1. Image source
  2. Timiraos, Nick. “Fed Debates How to Implement New Policy Strategy”. Wall Street Journal. Sept. 10, 2020. https://www.wsj.com/articles/fed-debates-how-to-implement-new-pol icy-strategy-11599730201
  3. McMahon, Tim. “Inflation in the 1980s”. Inflation Data. https://inflationdata.com/articles/ inflation-cpi-consumer-price-index-1980-1989/ 
  4. Volckart, Oliver. “Early beginnings of the quantity theory of money and their context in Polish and Prussian monetary policies, c. 1520–1550”. Wiley-Blackwell. 1997.  The Economic History Review
  5. FRED Economic Data. St. Louis Federal Reserve. 2020. https://fred.stlouisfed.org/.